A Stock Valuation Model

Different valuation models exist for a stock. One model is the Constant Growth Dividend Discount Model. This model works for a stock that is constantly growing its dividend. Not sure this applies to very many stocks. Here is the model and let's see what we can learn.

Valuation = Dividend Payout/(Risk Adjusted Interest Rate - Dividend Growth Rate)

We can make the model more applicable for most stocks by substituting Earnings for Dividend Payout and Earnings for Dividend.

What can we learn from this model?

• Valuations increase as the numerator, top, of the equation increases.
• Valuations increase as the denominator, bottom, of the equation decreases. The key is the difference in values between the interest rate and the growth rate.

How do valuations increase?

• As earnings grow because it decreases the denominator at a given interest rate.
• As the interest rate decreases because it decreases the denominator at a given earnings growth rate.

How do valuations decrease?

• As earnings decline because it increases the denominator at a given interest rate.
• As interest rates increase because it increases the denominator at a given earnings growth rate.

Let's look at the stock market at a peak. Typically, the Fed has raised interest rates to slow the economy. As the economy slows the growth rate declines. The higher interest rate and lower growth rate mean that the stock valuation declines perhaps at a rapid rate.

Let's look at the stock market at a peak. Typically, the Fed has reduced interest rates to grow the economy. As the economy grows the growth rate increases. The lower interest rate and higher growth rate mean that the stock valuation grows perhaps at a rapid rate.

Right now the interest rate is very low, below normal, and the growth rate is negative. Valuations change when the growth rate stabilizes and even grows. A math exercise: If the interest rate is 1% and the growth rate is -4% the denominator is 5%. If the growth rate goes to 0% and the interest rate is a value of 1% this means that valuation would 5 times higher.

The bottom line is at a market top or bottom, stock valuations can drop or raise at a faster rate than normal. This means that when the stock market recovers, which it will do eventually, valuations will increase at a rate much faster than normal.