Courtesy : Investopedia
Valuation methods typically fall into two main categories: absolute and relative.
Two Categories of Valuation Models
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 growth rate for a single company, and you wouldn't 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.
1. Dividend Discount Model (DDM)
The dividend discount model (DDM) is one of the most basic 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
In this example, the earnings per share are consistently growing at an average rate of 5%, and the dividends are also growing at the same rate. This means the firm's dividend is consistent with its earnings trend which would make it easy to predict for future periods. In addition, 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 is good, and makes this company an ideal candidate for the dividend model.
A procedure for valuing the price of a stock by using predicted dividends and discounting them back to present value. The idea is that if the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued.
This procedure has many variations, and it doesn't work for companies that don't pay out dividends. For example one variation is the supernormal dividend growth model which takes into account a period of high growth followed by a lower, constant growth period. The principal behind the model is the net present value of the cash flows. To get a growth number, one option is to take the return on equity (ROE) and multiply it by the retention ratio (which is 1-the payout ratio).
2. 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.
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 ten years, and then a terminal value is calculated to account for all of the cash flows beyond the forecast period. So, the first requirement for using this model is for the company to have predictable free cash flows, and for the free cash flows to be positive. Based on this requirement alone, you will quickly find that many small high-growth firms and non-mature firms will be excluded due to the large capital expenditures these companies generally face.
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
In this snapshot, the firm has produced increasingly positive operating cash flow, which is good. But you can see by the high level of capital expenditures that the company is still investing a lot of its cash back into the business in order to grow. This results in negative free cash flows for four of the six years, making it extremely difficult (nearly impossible) to predict the cash flows for the next five to ten years. So, in order 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 typically the mature firms that are past the growth stages. (To learn more about this method, see Taking Stock of Discounted Cash Flow.)
Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital, which we'll discuss in section 13 of this walk through) to arrive at a present value, which is then used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.
The formula for calculating DCF is usually given something like this:
PV = CF1 / (1+k) + CF2 / (1+k)2 + … [TCF / (k - g)] / (1+k)n-1
Where:
PV = present value
CFi = cash flow in year i
k = discount rate
TCF = the terminal year cash flow
g = growth rate assumption in perpetuity beyond terminal year
n = the number of periods in the valuation model including the terminal year
There are many variations when it comes to what you can use for your cash flows and discount rate in a DCF analysis. For example, free cash flows can be calculated as operating profit + depreciation + amortization of goodwill - capital expenditures - cash taxes - change in working capital. Although the calculations are complex, the purpose of DCF analysis is simply to estimate the money you'd receive from an investment and to adjust for the time value of money.
Discounted cash flow models are powerful, but they do have shortcomings. DCF is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out." Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, terminal value techniques are often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on.
At a time when financial statements are under close scrutiny, the choice of what metric to use for making company valuations has become increasingly important. Wall Street analysts are emphasizing cash flow-based analysis for making judgments about company performance.
DCF analysis is a key valuation tool at analysts' disposal. Analysts use DCF to determine a company's current value according to its estimated future cash flows. For investors keen on gaining insights on what drives share value, few tools can rival DCF analysis.
Accounting scandals and inappropriate calculation of revenues and capital expenses give DCF new importance. With heightened concerns over the quality of earnings and reliability of standard valuation metrics like P/E ratios, more investors are turning to free cash flow, which offers a more transparent metric for gauging performance than earnings. It is harder to fool the cash register. Developing a DCF model demands a lot more work than simply dividing the share price by earnings or sales. But in return for the effort, investors get a good picture of the key drivers of share value: expected growth in operating earnings, capital efficiency, balance sheet capital structure, cost of equity and debt, and expected duration of growth. An added bonus is that DCF is less likely to be manipulated by aggressive accounting practices.
DCF analysis shows that changes in long-term growth rates have the greatest impact on share valuation. Interest rate changes also make a big difference. Consider the numbers generated by a DCF model offered by Bloomberg Financial Markets. Sun Microsystems, which in 2012 traded on the market at $3.25, is valued at almost $5.50, which makes its price of $3.25 a steal. The model assumes a long-term growth rate of 13%. If we cut the growth rate assumption by 25%, Sun's share valuation falls to $3.20. If we raise the growth rate variable by 25%, the shares go up to $7.50. Similarly, raising interest rates by one percentage point pushes the share value to $3.55; a 1% fall in interest rates boosts the value to about $7.70.
Investors can also use the DCF model as a reality check. Instead of trying to come up with a target share price, they can plug in the current share price and, working backwards, calculate how fast the company would need to grow to justify the valuation. The lower the implied growth rate, the better - less growth has therefore already been "priced into" the stock.
Best of all, unlike comparative metrics like P/Es and price-to-sales ratios, DCF produces a bona fide stock value. Because it does not weigh all the inputs included in a DCF model, ratio-based valuation acts more like a beauty contest: stocks are compared to each other rather than judged on intrinsic value. If the companies used as comparisons are all over-priced, the investor can end up holding a stock with a share price ready for a fall. A well-designed DCF model should, by contrast, keep investors out of stocks that look cheap only against expensive peers.
DCF models are powerful, but they do have shortcomings. Small changes in inputs can result in large changes in the value of a company. Investors must constantly second-guess valuations; the inputs that produce these valuations are always changing and are susceptible to error.
Meaningful valuations depend on the user's ability to make solid cash flow projections. While forecasting cash flows more than a few years into the future is difficult, crafting results into eternity (which is a necessary input) is near impossible. A single, unexpected event can immediately make a DCF model obsolete. By guessing at what a decade of cash flow is worth today, most analysts limit their outlook to 10 years. Investors should watch out for DCF models that project to ridiculous lengths of time. Also, the DCF model focuses on long-range investing; it isn't suited for short-term investments.
Investors shouldn't base a decision to buy a stock solely on discounted cash flow analysis - it is a moving target, full of challenges. If the company fails to meet financial performance expectations, if one of its big customers jumps to a competitor, or if interest rates take an unexpected turn, the model's numbers have to be re-run. Any time expectations change, the DCF-generated value is going to change.
While many finance courses espouse the gospel of DCF analysis as the preferred valuation methodology for all cash flow generating assets, in practice, DCF can be difficult to apply in the valuation of stocks. Even if one believes the gospel of DCF, other valuation approaches are useful to help generate a complete valuation picture of a stock.
Alternative Methodologies : Even if one believes that DCF is the final word in assessing the value of an equity investment, it is very useful to supplement the approach with multiple-based target price approaches. If you are going to project income and cash flows, it is easy to use the supplementary approaches. It is important to assess which trading multiples (P/E, price/cash flow, etc.) are applicable based on the company's history and its sector. Choosing a target multiple range is where it gets tricky.
While this is analogous to arbitrary discount rate selection, by using a trailing earnings number two years out and an appropriate P/E multiple to calculate a target price, this will entail far fewer assumptions to "value" the stock than under the DCF scenario. This improves the reliability of the conclusion relative to the DCF approach. Because we know what a company's P/E or price/cash flow multiple is after every trade, we have a lot of historical data from which to assess the future multiple possibilities. In contrast, the DCF model discount rate is always theoretical, and we do not really have any historical data to draw from when calculating it.
3. 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.
This method can be used in almost all circumstances because of the vast number of multiples that can be applied, 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 one 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 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; earnings should not be too volatile and the accounting practices used by management should not drastically distort the reported earnings. (Companies can manipulate their numbers, so you need to learn how to determine the accuracy 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.
No one valuation method is perfect for every situation, but by knowing the characteristics of the company, you can select the 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.