Analyst's Toolkit: A Deal on Dominion Shares

RICHMOND, Va. (TheStreet) -- What's a stock worth? That's the hardest question analysts confront. It's also one of the most important: A target price helps investors evaluate how much they could gain by owning a company's shares.

When it comes to companies of similar size, like General Electric(GE Quote) and Google(GOOG Quote), shares outstanding and earnings are the usually the biggest factors influencing their share prices. But those are backward-looking measures. The trick is to predict a company's future profitability. You can find clues by evaluating a company's dividends.

The dividend discount model offers a way to evaluate the present value of a company's future cash flow, a key measure of an investment. This method sets a target price by extrapolating the growth rate of a company's dividends and comparing them to the required return, the amount an investor needs to make.

Here's the formula: target price = (dividend x (1+ growth rate)) / (required return - growth rate)

It's not as difficult as it looks. For the growth rate, you can use the company's sustainable growth rate. You can set a required return by using the capital asset pricing model, or CAPM.

This method works best on established companies that are likely to pay dividends indefinitely, such as utilities. Erratic dividends lead to useless data. Let's try it on the electric companies Dominion Resources(D Quote) of Richmond, Va., and Atlanta-based Southern Co.(SO Quote) Here are the data for the firms:

Dominion Southern Required return 8.60% 7.60% Dividend 1.75 1.75 Return on equity 18.80% 11.70% Retention ratio 22.00% 13.00% Target price $40.61 $29.36

Southern appears overvalued at its current price of $31.26 by almost $1 per share, which suggests investors won't be adequately compensated by the stock at this price.