Investors need to evaluate stocks to know their value. By finding the value of a stock, investors can compare them with other stocks and determine whether the investment is worthwhile.
Investors can also find the fair value, or intrinsic value, of a stock to determine whether a stock is overvalued, undervalued or fairly valued in the stock market.
When it comes to finding out the fair value of stocks, there are many equity valuation methods to choose from. Investors are often confused between which valuation method to use and which of these valuation methods to use.
However, investors must understand that there are 2 main categories of equity valuation models. These methods can either find the absolute value of a stock or the relative value of a stock.
1) Absolute valuation
Absolute valuation models find the fair value of a stock, also known as its intrinsic value. The models used in this category are a bit complex compared to relative and other valuation models.
Furthermore, the models in this category use the concept of time value of money to determine the fair value of a company’s stock.
In addition, these models use discounted projected cashflows estimates of a company’s stock to determine the absolute value of a stock.
There are mainly two models to find out the absolute value of a stock, the Dividend Discount Model (DDM), and its variants, and the Discounted Cash Flow Model (DCF).
2) Dividend Discount Model (DDM)
The dividend discount model is one of the most widely used models by investors to determine the fair value of a stock. This model assumes that the fair value of a stock is equal to the discounted sum of all its future dividends.
In simple terms, this model assumes that the present value of a company’s stock is equal to any future dividends the investors will receive.
To calculate the fair value of a stock using the Dividend Discount Model, the following formula can be used:
Value of stock = Expected future dividends per share / (Cost of Capital Equity – Dividend growth rate)
However, this model can only be used for stocks of companies that pay dividends. If a company does not pay dividends, this method will not produce any result. For companies that don’t pay dividends, the Discounted Cash Flow Model is used.
3) Discounted Cash Flow Model (DCF)
Unlike the Dividend Discount Model, the Discounted Cash Flow Model does not require a company to pay dividends to determine the absolute value of its stock.
However, this model can still be used for companies that do pay dividends. Instead of future dividends, this model considers the future cash flows of a company’s stock.
This model assumes that the fair value of a stock is equal to the discounted sum of all its future cashflows. These cash flows can be either in any form including cashflows from dividends.
The formula to calculate the fair value of a stock using Discounted Cash Flows Model is as follows:
Discounted Cash Flows = Cashflow for Year 1 x (1 + r)^-1+ Cashflow for Year 2 x (1 + r)^-2 + ….. Cashflow for Year n x (1 + r)^-n
Where r is the discount rate and n is the number of years of the investment.
4) Relative valuation
The relative valuation, unlike absolute valuation, of a company’s stock does not look into the stock’s fair value but rather uses ratios to compare information about different stocks.
It’s an easier alternative for investors to understand, especially for those who do not understand complex topics such as the time value of money, a concept used in all the absolute valuation models.
The main method used in the relative valuation category is the comparables method.
5) The Comparables Method
In the comparables method, also known as the multiples method, investors simply find out different ratios related to the stock of a company and compare them to the company’s competitors’ ratios and the industry averages.
Ratios such as Price-to-Earnings (P/E) ratio, Price-to-Sales (P/S) ratio, Price-to-Book (P/B) ratio, Price-to-Cash-Flows (P/CF) ratio, and the Enterprise-Value-to-Earnings (Before Interest, Tax, Depreciation, and Amortization) ratio (EV/EBITDA).
These ratios are also called multiples and, therefore, the method is also called the multiples method.
This method is comparatively easier to use for investors as most of the information is readily available in the market or the company’s financial statements.
Furthermore, this method does not make assumptions as is the case with the Dividend Discount Model and the Discounted Cash Flow Model.
It is also important to consider that it is very difficult to find companies that are truly comparable. For example, in the smartphone market, Apple Inc. and Samsung Inc. are two competitors at the highest level.
However, Samsung also deals in other types of consumer electronics. Therefore, these companies cannot be truly compared.
Asset-based Valuation Categories
Investors can also use other relative valuation methods to find out the value of the equity of a stock. Some of these methods are based on the value of a company’s assets value.
The information in these methods can easily be derived from information available to the public.
The Book Value Method
Investors can use the book value method to derive the value of their stock. The Book Value of a company is its net worth. This value can easily be found on the balance sheet of a company. The book value of a company can be found by looking at the total shareholders’ equity on its balance sheet.
The Liquidation Value Method
The liquidation value method is also based on the value of a company’s assets like the book value method but instead of finding the net worth of a company, the liquidation value of a company is considered.
The liquidation value of a company is the net realizable value of its assets less any short-term liabilities and less preference shareholders capital.
Choosing an Equity Valuation Method
There are many models and methods that investors can use to find the value of a stock. Investors are often confused as to which of these methods is the best or produces the most accurate result.
When choosing an equity valuation method to use, investors must consider the amount and type of information available to them.
For example, if an investor is looking at companies that pay dividends, they can use the Dividend Discount Model but if the companies do not pay dividends, this model cannot be used.
Similarly, if the information about the competitors of a company or its industry average is not available, investors will have a hard time using the comparables method.
In addition, some of the models used for equity valuation are based on some assumptions. If these assumptions are not true, the models will fail to give an accurate result. Therefore, investors should not rely on only a single model or method of equity valuation.
There are different equity valuation methods that investors can use to determine the value of a stock. These equity valuation methods fall into two main categories namely absolute valuation and relative valuation. When choosing an equity valuation method, investors must consider the information available to them.