Present value models are based on the principle that individuals defer current consumption in expectation of future (higher) benefits. Hence, the value today must equal the future benefits considering the required return. There are two types of present value models: the dividend discount model and the free cash flow to equity model.
Dividend discount model
Under the dividend discount model, the value of a stock of a company that is a going concern is the present value of an indefinite stream of dividends. This assumption is appropriate because companies are typically set up to operate indefinitely.
If an investor intends to hold a stock indefinitely, the value of a dividend-paying stock is given by the following formula:
Where V0 is the value at time 0, Dt is the expected dividend in time period t, and r is the required rate of return.
If an investor intends to hold a stock for a finite number of periods, the value of the stock depends on the expected dividends received during the holding period and the expected terminal value (also called the horizon value), which in turn depends on dividends expected after the holding period.
The general expression for value, in this case, is given by the following equation:
Free cash flow to equity model
Sometimes analysts value a company using the free cash flow to equity model which is based on the capacity to pay dividends and not just expected dividends. This approach is particularly useful when a company does not pay dividends.
Free cash flow to equity (FCFE) equals cash flow from operating activities minus expected capital expenditure plus net borrowing:
FCFE = CFO – FCInv + Net\ Borrowing
The required rate of return on equity (re) is typically estimated using the capital asset pricing model:
r_e = r_f + \beta × (r_m – r_f)
Where rf , β, and rm refer to risk-free rate, beta coefficient and market return.
Other methods include starting with the risk-free rate and adding premiums for different risks.