In simple layman language, the meaning of valuation is the process of determining the current worth of an asset or company. Analysts use various valuation models to estimate the intrinsic values of stocks and compare the value derived to the stocks’ market prices to determine whether individual stocks are overvalued or undervalued. In doing valuation the analysis for stocks, analysts are assuming that some stocks’ prices deviate significantly from their intrinsic values. To the extent that market prices diverge from intrinsic values, analysts who can assess a stock’s intrinsic value better a compared to the market can earn huge profits if the market price moves toward its intrinsic value over time. The greater the percentage variance between estimated values and market prices, the more probable the investor is to take a position which will be based on the estimate of intrinsic value. The more convinced the investor is about the estimated inputs used in the valuation model, the more probable the investor is to take an investment position in a stock that is identified as overvalued or undervalued. Even if the market prices sometimes deviate from intrinsic values, market prices must be treated as reasonably reliable indications of intrinsic value. Eventually, to take a position in a stock identified as wrongly priced in the stock market, an investor must understand that the market price will move toward its calculated intrinsic value and that it will do so to a notable extent within the investment time horizon.
CATEGORIES OF EQUITY VALUATION MODELS.
Analysts use various models to estimate the value of equities. Customarily, an analyst will use more than one model with several different sets of inputs to determine a range of possible stock values.
Valuation Model
1) Absolute Valuation Model
2) Relative Valuation Model
Absolute Valuation Model – This model attempt to find the intrinsic or “true” value of an investment based only on fundamentals. Looking at fundamentals mean to focus on such things as growth rate, dividends, and cash flow for a single firm, and not worry about any other firms. Valuation models that fall into this category include the following:
- Dividend discount model.
- Discounted cash flow model.
- Residual income models.
- Asset-based models.
Relative Valuation Model- This model operates by comparing the company in question to other similar companies. These methods involve a calculation of various multiples or ratios, like looking at the price-to-earnings multiple and comparing it to the multiples of other comparable organizations. For example, if the P/E of the firm is lower as compared to the P/E multiple of a similar company, that firm may be supposed to be relatively undervalued. Generally, this type of valuation is a lot easier and quicker to do than the absolute valuation method that is why many investors and analysts prefer this method of valuation. This method is popular due to the ample number of multiples that can be used, like price-to-book (P/B), the price-to-earnings (P/E), price-to-cash flow (P/CF), price-to-sales (P/S), and many others.
Asset-Based model
This is one of the absolute valuation methods where the intrinsic value of common stock is estimated as complete asset value minus liabilities and preferred stock. This method focuses on a company’s net asset value or the fair market value of its total assets minus its total liabilities. The asset-based approach asks what it would cost to recreate the business. Analysts usually adjust the book values of the organization’s assets and liabilities to their fair values while estimating the market value of its equity with an asset-based model.
Asset values used can be:
- Book value – the book value of assets as can be traced from the financial statements
- Replacement cost – the buyer of a business, will be interested in the replacement cost
- Net realizable value – the seller of a business will usually see the realizable value of assets as the minimum acceptable price in negotiations.
However, it is to be noted that replacement cost is not easy to identify in practical life and the business is more than just the summation of the assets and liabilities.
Advantages of asset-based models:
- They are most reliable when the company has primarily assets with ready market values, tangible short-term assets, or when the firm is being liquidated.
- They can provide floor values.
- They are increasingly helpful for valuing public companies that report fair values.
Disadvantages of asset-based models:
- Market values are normally different than book values.
- Market values are often difficult to obtain.
- They are incorrect when a firm has a high proportion of intangible assets or future cash flows not reflected in asset values.
- Assets can be challenging to value during periods of hyperinflation
The Residual Income Method
Residual Income Method is one of the absolute methods of valuation where the income generated by an organisation after accounting for the true cost of its capital. In calculating the residual income, the key component is to determine its equity charge. Equity charge is nothing but the firm’s total equity capital is multiplied by the required rate of return. The Required rate of return can be calculated by using the CAPM. The formula for calculating the equity charge is below.
Equity Charge = Equity Capital x Cost of Equity
Once Equity charge is calculated, we have to subtract it from the firm’s net income to come up with its residual income.
Example:
Suppose a Company X had reported earnings of $100,000 last year and financed its capital structure with $800,000 worth of equity at a required rate of return of 10%, its residual income would be:
Equity Charge = Equity Capital x Cost of Equity = $800,000X 0.10 = $80,000/-
Therefore Residual Income= Net Income- Equity Charge = $100,000 – $80,000
= $20,000/-
The Residual Income of the future years so calculated is discounting using the appropriate discounting rate. This residual income valuation formula is very alike to a multistage dividend discount model, substituting future dividend payments with future residual earnings. In contrast to the DCF approach, that uses the weighted average cost of capital (WACC) for the discount rate, the relevant rate for the residual income strategy is the cost of equity.
Free cash flow to equity (FCFE)
Free cash flow to equity (FCFE) is often used because it describes the potential amount of cash that can be paid out to common shareholders. FCFE indicates the firm’s ability to pay dividends. As opposed to Dividend Discount Model (DDM), this FCFE is also useful for firms that do not currently pay dividends.
FCFE is based on the logic of cash remaining after an organization meets all of its debt debts and grants for the capital expenditures needed to maintain existing assets and to acquire the new assets needed to continue the assumed growth of the firm. This model only takes into account the cash available to the firm’s equity holders after a firm meets all of its other obligations.
FCFE for a period is calculated as follows:
FCFE = net income + depreciation – increase in working capital – fixed capital investment(FCinv) – debt principal repayments + new debt issues
FCFE can also be calculated as:
FCFE = cash flow from operations- FCinv + net borrowing
The primary distinction between the dividend discount models and the free cash flow to equity models is that the dividend discount model refers expected dividends on the stock, whereas the FCFE model utilizes an expansive definition of cash flow to equity after meeting all financial obligations and investment needs. When firms have dividends that are different from the FCFE, the values from the two models will be different. In valuing firms for takeovers, mergers, amalgamation, the value from the FCFE provides a better estimate of value.
Dividend Discount Model (DDM)
The dividend discount model (DDM) is based on the explanation that the intrinsic price of the stock is the current value of its future dividends. This model is one of the most fundamental of the absolute valuation models. The dividend model determines the “true” value of a firm based on the dividends the business pays its shareholders. The notion is that if the rate obtained from DDM is more than the price at which the shares are currently trading at, then the stock is undervalued.
Value of stock= Dividend per share/ (Discount Rate- Dividend Growth Rate)
The most general form of the model is as follows:
V0= Sum( Dt/(1+Ke)^t)
where:
V0 = current stock value
Dt = dividend at a time taken
ke = required rate of return on the common equity
E.g.:
Consider a company with a $1 annual dividend. If one feels that the company will pay that dividend indefinitely, then one must ask what should be the correct price to pay for that firm. Assume expected return is 5%. According to the DDM, the company should be worth $20 ($1.00 / .05).
Another shortcoming of the model is that one cannot expect most companies to grow over time. If this had been the case, then the denominator equals the anticipated return less the dividend growth rate. This is called the constant growth DDM or the Gordon model. Let’s say that the company’s dividend will grow by 3% annually; then the value should be $1 / (.05 – .03) = $50
This model has many lacunae as it cannot be used on a firm that does not give dividends. The most common form of DDM uses an infinite holding period because a company has an infinite life. In an unbounded-period DDM model, the present value of all expected future dividends is calculated, and there is no explicit terminal value for the stock. In practice, a terminal value can be calculated at a time in the future, after which the growth rate of dividends is assumed to be constant.