Two Categories of Valuation Models
Valuation methods typically fall into two main categories: absolute and relative valuation models. Absolute valuation models attempt to find the intrinsic or "true" value of an investment based only on fundamentals. Looking at fundamentals simply mean you would only focus on such things asdividends, cash flow and growth rate for a single company, and not worry about any other companies. Valuation models that fall into this category include the dividend discount model,discounted cash flow model, residual income models and asset-based models.
In contrast to absolute valuation models, relative valuation models operate by comparing the company in question to other similar companies. These methods generally involve calculating multiples or ratios, such as the price-to-earnings multiple, and comparing them to the multiples of other comparable firms. For instance, if the P/E of the firm you are trying to value is lower than the P/E multiple of a comparable firm, that company may be said to be relatively undervalued. Generally, this type of valuation is a lot easier and quicker to do than the absolute valuation methods, which is why many investors and analysts start their analysis with this method.
Let's take a look at some of the more popular valuation methods available to investors, and see when it is appropriate to use each model. (For related reading, see Top Things To Know For An Investment Banking Interview.)
Dividend Discount Model (DDM)
The dividend discount model (DDM) is one of the most basic of the absolute valuation models. The dividend model calculates the "true" value of a firm based on the dividends the company pays its shareholders. The justification for using dividends to value a company is that dividends represent the actual cash flows going to the shareholder, thus valuing the present value of these cash flows should give you a value for how much the shares should be worth. So, the first thing you should check if you want to use this method is if the company actually pays a dividend.
Secondly, it is not enough for the company to just a pay dividend; the dividend should also be stable and predictable. The companies that pay stable and predictable dividends are typically mature blue-chip companies in mature and well-developed industries. These type of companies are often best suited for this type of valuation method. For instance, take a look at the dividends and earnings of company XYZ below and see if you think the DDM model would be appropriate for this company:
2005 | 2006 | 2007 | 2008 | 2009 | 2010 | |
Dividends Per Share | $0.50 | $0.53 | $0.55 | $0.58 | $0.61 | $0.64 |
Earnings Per Share | $4.00 | $4.20 | $4.41 | $4.63 | $4.86 | $5.11 |
Discounted Cash Flow Model (DCF)
What if the company doesn't pay a dividend or its dividend pattern is irregular? In this case, move on to check if the company fits the criteria to use the discounted cash flow model. Instead of looking at dividends, the DCF model uses a firm's discounted future cash flows to value the business. The big advantage of this approach is that it can be used with a wide variety of firms that don't pay dividends, and even for companies that do pay dividends, such as company XYZ in the previous example.
For example, take a look at the simplified cash flows of the following firm:
2005 | 2006 | 2007 | 2008 | 2009 | 2010 | |
Operating Cash Flow | 438 | 789 | 1462 | 890 | 2565 | 510 |
Capital Expenditures | 785 | 995 | 1132 | 1256 | 2235 | 1546 |
Free Cash Flow | -347 | -206 | 330 | -366 | 330 | -1036 |
Comparables Method
The last method we'll look at is sort of a catch-all method that can be used if you are unable to value the company using any of the other models, or if you simply don't want to spend the time crunching the numbers. The method doesn't attempt to find an intrinsic value for the stock like the previous two valuation methods do; it simply compares the stock's price multiples to a benchmark to determine if the stock is relatively undervalued or overvalued. The rationale for this is based off of the Law of One Price, which states that two similar assets should sell for similar prices. The intuitive nature of this method is one of the reasons it is so popular.
The reason why it can be used in almost all circumstances is due to the vast number of multiples that can be used, such as the price-to-earnings (P/E), price-to-book (P/B), price-to-sales (P/S),price-to-cash flow (P/CF), and many others. Of these ratios though, the P/E ratio is the most commonly used one because it focuses on the earnings of the company, which is one of the primary drivers of an investments value.
When can you use the P/E multiple for a comparison? You can generally use it if the company is publicly traded because you need the price of the stock and you need to know the earnings of the company. Secondly, the company should be generating positive earnings because a comparison using a negative P/E multiple would be meaningless. And lastly, the earnings quality should be strong. That is, earnings should not be too volatile and the accounting practices used by management should not distort the reported earnings drastically. (Companies can manipulate their numbers, so you need to learn how to determine the accuracy of EPS. Read How To Evaluate The Quality Of EPS.)
These are just some of the main criteria investors should look at when choosing which ratio or multiples to use. If the P/E multiple cannot be used, simply look at using a different ratio such as the price-to-sales multiple.
The Bottom Line
No one valuation method is perfect for every situation, but by knowing the characteristics of the company, you can select a valuation method that best suits the situation. In addition, investors are not limited to just using one method. Often, investors will perform several valuations to create a range of possible values or average all of the valuations into one.
DiscoverCI
Great Post! In practice, we primarily use the dividend discount model, and discounted cash flow model. It's not easy to go through the process of compiling the information, but it's important to fully analyze a stock before investing.
We've always used excel to calculate a stock's intrinsic value using the discounted cash flow and dividend discount, but recently we developed an online valuation model (along with checklists) that automates a lot of the analysis. Our automated stock valuation models are free to use, and can greatly speed up the process of calculating a company's intrinsic value.
Here is a link if you'd like to check it out: https://www.discoverci.com/companies/AAPL/stock-valuation.
2019-10-25 05:00