When deciding which valuation method to use to value a stock for the first time, it's easy to become overwhelmedby the number of valuation techniques available to investors. There are valuation methods that are fairly straightforward, whileothers are more involved and complicated.
Unfortunately, there'sno one method that'sbest suited for every situation. Each stock is different, and each industry or sector has unique characteristics that may require multiplevaluation methods. In this article, we'll explore the most common valuation methods and when to use them.
Key Takeaways
- There are several methods for valuing a company or its stock, each with its own strengths and weaknesses.
- Some models try to pin down a company's intrinsic value based on its own financial statements and projects, while others look to relative valuation against peers.
- For companies that pay dividends, a discount model like the Gordon growth model is often simple and fairly reliable—but many companies do not pay dividends.
- Often, a multiples approach may be employed to make comparative evaluations of a company's value in the market against its competitors or broader market.
- When choosing a valuation method, make sure it is appropriate for the firm you're analyzing, and if more than one is suitable use both to arrive at a better estimate.
Two Categories of Valuation Models
Valuation methods typically fall into two main categories: absolute valuation and relative valuation.
Absolute Valuation
Absolute valuation models attempt to find the intrinsic or "true" value of an investment based only on fundamentals. Looking at fundamentals simply means you would only focus on such things as dividends, cash flow, and the 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 model, and asset-based model.
Relative Valuation
Relative valuation models, in contrast, operate by comparing the company in question to other similar companies. These methods involve calculating multiples andratios, such as the price-to-earnings (P/E) ratio, and comparing them to the multiples of similar companies. For example, if the P/E of acompanyis lower than the P/E of a comparable company, theoriginal company might be consideredundervalued. Typically, the relative valuation modelis a lot easier and quicker to calculatethan the absolute valuation model, which is why many investors and analysts begintheir analysis with this model.
Let's take a look at some of the more popular valuation methods available to investors, and see when it'sappropriate to use each model.
Dividend Discount Model (DDM)
The dividend discount model (DDM)is one of the most basic of the absolute valuation models. The dividend discount 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, so valuing the present value of these cash flows should give you a value for how much the shares should be worth.
The first step is to determine if the company pays a dividend.
The second step is to determine whether the dividend is stable and predictable since it'snot enough for the company to just pay a dividend.The companies that pay stable and predictable dividends are typically mature blue chip companies in well-developed industries. These types of companies are often best suited for the DDMvaluation model. For instance, reviewthe dividends and earnings of company XYZ below and determineif the DDM model would be appropriate for thecompany:
| 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | |
| 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 |
In the aboveexample, the earnings per share (EPS) is consistently growing at an average rate of 5%, and the dividends are also growing at the same rate. The company'sdividend is consistent with its earnings trend, which should make it easy to predict dividends forfuture periods. Also, you should check the payout ratio to make sure the ratio is consistent. In this case, the ratio is 0.125 for all six years, which makes this company an ideal candidate for the dividend discount model.
The Gordon Growth Model (GGM) is widely used to determine the intrinsic value of a stock based on a future series of dividends that grow at a constant rate. It is a popular and straightforward variant of a dividend discount mode (DDM).
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 thediscounted cash flow (DCF) 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.
The DCF model has several variations, but the most commonly used form is the Two-Stage DCF model. In this variation, the free cash flows are generally forecasted for five to 10 years, and then a terminal value is calculated to account for all the cash flows beyond the forecasted period. The first requirement for using this model is for the company to have positive and predictable free cash flows. Based on this requirement alone, you willfind that many small high-growth companiesand non-mature firms will be excluded due to the large capital expenditures these companies typicallyencounter.
For example, let's take a look at the cash flows of the following firm:
| 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | |
| 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 |
In this snapshot, the firm has produced an increasing positive operating cash flow, which is good. However, you can see by the large amountsof capital expenditures that the company is still investing muchof its cash back into the business in order to grow. As a result, the company hasnegative free cash flows for four of the six years, which makes it extremely difficult or nearly impossible to predict the cash flows for the next five to 10 years.
To use the DCF model most effectively, the target company should generally have stable, positive, and predictable free cash flows. Companies that have the ideal cash flows suited for the DCF model are typicallymature firms that are past the growth stages.
Discounted Cash Flow (DCF)
The Comparables Model
The last model is sort of a catch-all model 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. This model doesn't attempt to find an intrinsic value for the stock like the previous two valuation models. Instead,it 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 onthe Law of One Price, which states that two similar assets should sell for similar prices. The intuitive nature of this model is one of the reasons it is so popular.
The reason why the comparables model can be used in almost all circ*mstances 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, the P/E ratio is the most commonly used because it focuses on the earnings of the company, which is one of the primary drivers of an investment's value.
When can you use the P/E multiple for a comparison? You can typicallyuse it if the company is publicly traded sinceyou'll need both the stock price and 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. 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.
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, choose a different ratio, such as the price-to-salesor price-to-cash flow multiples.
Are Absolute or Relative Valuation Models Better?
Neither type of model is explicitly better than the other. Each has pros and cons. Relative valuation, for example, is often quicker because it relies on comparing key stats for different companies. Absolute valuation can take longer because of the research and calculations involved, but it can offer a more detailed picture of a company's value.
Why Would a Stock's Price Differ From Its Calculated Value?
Some valuation methods, such as the discounted cash flow method, use a company's financial stats to determine its value. Any investor using the method should produce the same result. However, the market price of a stock can differ from its calculated value because investor sentiment is positive and people believe the company will increase profitability, or because of fears of future underperformance.
Why Are Stock Valuation Models Useful?
Investing is all about trying to earn a return from the money you've invested. When it comes to stocks, you want to buy shares at a low price and receive dividends or sell them for a higher price. Stock valuation models can help you determine whether a stock's market price is higher or lower than its true value, helping you know whether it's a good idea to buy or sell shares.
What's the Fastest Stock Valuation Method?
If you're looking to quickly determine the value of a stock, relative valuation methods are typically faster than absolute methods. You can compare the financial stats of two companies to get a sense of their values more quickly than you can do the calculations required by an absolute valuation model.
The Bottom Line
No singlevaluation model fitsevery situation, but by knowing the characteristics of the company, you can select a valuation model that best suits the situation. Additionally, investors are not limited to just using one model. Often, investors will perform several valuations to create a range of possible values or average all of the valuations into one. With stock analysis,sometimes it'snot a question of the right tool for the job but ratherhow many tools you employ to obtain varyinginsights from the numbers.
