A Comparison of Dividend Cash Flow & Earnings Approaches to Equity Valuation
Original post by Herb Kirchhoff of Demand Media
There are many approaches to valuing a company's equity, more commonly known as its stock. A share of stock represents partial ownership of the company. Not all companies are worth buying an ownership share. Three common ways of determining whether a company's stock is a good investment are to look at dividends, cash flow and earnings per share.
Dividends are company profits that are shared with stockholders as a cash payment per share. Dividends are one of the two ways stocks reward investors. The other is selling your stock to someone else for more than you paid to buy it. Cash flow is the company's operating money. Earnings per share is the company's total net income divided by the number of shares outstanding. Each of these measures represents a different way of looking at a particular stock.
Companies determine their per-share dividend by dividing the profits going to the stockholders by the number of shares outstanding. Dividends typically are paid each quarter. In the dividend valuation method, you add together all the dividends you expect to receive over the span of years that you expect to own the stock, plus the projected increase in the per-share price over that time span. You divide that sum by the years you plan to own the stock to find your annual rate of return on the money you spend to buy the stock. You compare that return with the returns on other possible investments. Companies with a long record of paying large dividends tend to be good investments.
Cash flow is the amount of money that flows through a company's operations during a quarter or year. It's normally defined as earnings before interest, taxes, depreciation and amortization (EBITDA) and this figure is public information. Interest and taxes affect net income, not available cash, while depreciation and amortization are tax- and cost-accounting conventions that are booked as expenses but don't represent actual cash outlays. Analysts use EBITDA operating cash flow to value company stocks in industries such as telecommunications with huge up-front capital costs and high amortization of valuable but intangible assets such as goodwill. Such companies may report losses on paper while they are building up the business but actually are generating huge amounts of cash. Companies that are cash-rich tend to be good investments.
The thing to look for with net earnings per share is whether the company over time consistently meets or beats its forecasts of per-share earnings or must frequently restate and lower its earnings forecasts. There are two ways of reporting earnings per share. One is the unadjusted figure computed according to generally accepted accounting principles (GAAP). The other is known as "pro forma" earnings per share, which has been adjusted to exclude one-time events and non-cash items like amortization of goodwill. The pro forma earnings figure is the one most stock analysts use. Companies with a consistent history of meeting net earnings forecasts tend to be good investments.
- ABC Stock Investing.com: Stock Valuation Methods, Earnings Per Share
- Stock Market Investors.com: Cash Flow Valuation
- James Madison University; Dividend Valuation Models; Pamela Drake, Ph.D., CFA; 2007
About the Author
Herbert Kirchhoff has over 35 years experience as a newspaper and newsletter reporter, writer and editor, with 27 of those years spent on telecommunications industry policy issues. Kirchhoff has a B.A. in journalism from Rider University in New Jersey and has been published in the "Trenton (N.J.) Times" and in "Communications Daily" and State Telephone Regulation Report, Washington, D.C.