You learned about the present value of a future payment in our Time Value of Money lesson. Surprisingly, we can use this concept to value stocks.

The value of a stock is, in fact, the value of all payments an investor will receive from a business over its lifetime; thus, it is the current value of all future dividend payments.

For example, suppose the Jack Company has a net income of $10,000. Tthere are 1000 shares of stock outstanding; thus, the Jack Co's earnings per share is $10. Additionally, the Jack Co is trading at a price of $100 per share. The Jack Co is not growing at the moment and its return on equity is 20%.

Since the company is not growing, we expect the free cash flow to be roughly equal to its net income; thus, we can predict that the company will be able to pay approximately $10 per share in dividends each year, and we can predict that its its free cash flow/net income ratio will be about 1. Since the stock is selling for $100 per share, you can expect that if you invest in The Jack Co, you will earn an interest rate(also known as a discount rate) of approximately 10%.

Look to the calculator on the right. Enter $10 next to "Initial Earnings Per Share", enter 10 next to "Discount Rate", enter 1 in each free cash flow/net income column. Now, click on the "Calculate" button. Just as we expected, the intrinsic value of The Jack Co is $100 per share.

However, suppose the Jack Co wants to grow his business. He feels that he can grow his company by 10% per year for the next 5 years. Now comes a more difficult part: estimating the company's free cash flow to net income ratio. In our Return on Equity article, we mentioned that free cash flow can be expected to be roughly equal to Net Income X (return on equity - growth rate)/Return on Equity. Divide both sides by Net Income, and we get: Free Cash Flow/Net Income = (return on equity - growth rate)/(Return on Equity), which in this case, is (20%-10%/20%), or 0.5. Enter 0.5 in the first free cash flow/net income column. Next, Enter 10 next to the "1-5" column. Now, click "Calculate." The current value of the company is now $125 per share! Five years of growth has created $25 per share in value.

Jill's company is just like Jack's company, except her company's return on equity is only 5%. The free cash flow/net income ratio should -1 (5%-10%/5% = -1), so Enter -1 in the free cash flow/net income column. The intrinsic value of the Jill Company is only $50 per share! If Jill grows her business by 10% per year for the next five years, $50 per share in value will be destroyed!