Discounted net present value is the way to arrive at a target share price of a stock. It is the most mathematical thing we do as focus investors. Usually we calculate a target share price once we have decided that the company is a good one to invest in.
You can use a spreadsheet on the computer to do the computations rather than doing it by paper and pencil. Generally, you add up all of the profit for the next 5 or 10 years, then calculate the discounted net present value of that amount. You could also use the dividend payment if there is one rather than profit or earnings.
Let’s take Walmart (WMT) for example. The dividend is currently $2.12 per share per year. Over 10 years that would be 21.20. However, the dividend has been growing by 4 cents per year. So that adds up to $23. If we used a discount rate of 5%, the discounted net present value is $14.12. This is probably about 1/10th of the current share price. So that might indicate to you not to buy.
We could stretch out Walmart to 20 or 30 years since we are fairly confident that the company will continue to be around. We could also add a share price that we expect the company to be worth at the end. Or we could use profit instead of dividends. Maybe the discount could be less.
As you can see, the discounted net present value can be fairly subjective. Subjective meaning different people can have different opinions of what the share price should be. What really matters is what you think. Ultimately you might even decide to buy the stock at a price above the target share price you have calculated. What’s most important is that you do it with your eyes wide open.
What if a company is not profitable yet? Your job is then to figure out when it will be and how much profit will be generated once it is.
What if a company is cyclical… some companies do better one year and then go down the next. As always, figure out the profit over a long period then the discounted NPV to get a target stock price.
With all that was said here, it bears repeating that a target stock price does not select a stock. It only prices a stock that is already selected. You can eliminate most stocks by just looking at debt and cash, revenue growth, and return on equity. You may also be able to come up with your own selection criteria. I feel that some simple rules make it easy to eliminate most companies… but they do not automatically select a stock. Study your method. Work with your best ideas.
- Net Present Value (NPV), Explained in 400 Words or Less – Meredith Hart
- How To Use Net Present Value In Real Estate Investing Calculations – Mashvisor
- NPV (Net Present Value) – Markido
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