Complete Guide To Corporate Finance


Stock Valuation - Common Stock Valuation

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. (For related reading, see Top Things To Know For An Investment Banking Interview.)

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:

Dividends Per Share
Earnings Per Share

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. (For more on the DDM, see Digging Into the Dividend Discount Model.)

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:

Operating Cash Flow
Capital Expenditures
Free Cash Flow

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.)

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. (For more on this subject, see 6 Basic Financial Ratios And What They Reveal.)

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. 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.

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.

Preferred Stock Valuation
Related Articles
  1. Investing

    What a Family Tradition Taught Me About Investing

    We share some lessons from friends and family on saving money and planning for retirement.
  2. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  3. Professionals

    4 Must Watch Films and Documentaries for Accountants

    Learn how these must-watch movies for accountants teach about the importance of ethics in a world driven by greed and financial power.
  4. Personal Finance

    How Tech Can Help with 3 Behavioral Finance Biases

    Even if you’re a finance or statistics expert, you’re not immune to common decision-making mistakes that can negatively impact your finances.
  5. Investing Basics

    5 Tips For Diversifying Your Portfolio

    A diversified portfolio will protect you in a tough market. Get some solid tips here!
  6. Entrepreneurship

    Identifying And Managing Business Risks

    There are a lot of risks associated with running a business, but there are an equal number of ways to prepare for and manage them.
  7. Active Trading

    An Introduction To Depreciation

    Companies make choices and assumptions in calculating depreciation, and you need to know how these affect the bottom line.
  8. Forex Education

    Explaining Uncovered Interest Rate Parity

    Uncovered interest rate parity is when the difference in interest rates between two nations is equal to the expected change in exchange rates.
  9. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  10. Economics

    Understanding Tragedy of the Commons

    The tragedy of the commons describes an economic problem in which individuals try to reap the greatest benefits from a given resource.
  1. Accountant

    A professional who performs accounting functions such as audits ...
  2. Rule Of 72

    A shortcut to estimate the number of years required to double ...
  3. Laissez Faire

    An economic theory from the 18th century that is strongly opposed ...
  4. Personal Finance

    All financial decisions and activities of an individual or household, ...
  5. Audit

    An unbiased examination and evaluation of the financial statements ...
  6. Put-Call Parity

    A principle that defines the relationship between the price of ...
  1. What should I study in school to prepare for a career in corporate finance?

    Depending on which area you want to specialize in, corporate finance can be one of the most competitive fields in business. ... Read Full Answer >>
  2. Why would a company issue preference shares instead of common shares?

    Preference shares, or preferred stock, act as a hybrid between common shares and bond issues. As with any produced good or ... Read Full Answer >>
  3. What is the difference between cost of debt capital and cost of equity?

    In corporate finance, capital – the money a business uses to fund operations – comes from two sources: debt and equity. While ... Read Full Answer >>
  4. What is the difference between gross profit, operating profit and net income?

    The terms profit and income are often used interchangeably in day-to-day life. In corporate finance, however, these terms ... Read Full Answer >>
  5. What’s the difference between the two federal student loan programs (FFEL and Direct)?

    The short answer is that one loan program still exists (Federal Direct Loans) and one was ended by the Health Care and Education ... Read Full Answer >>
  6. Can working capital be depreciated?

    Working capital as current assets cannot be depreciated the way long-term, fixed assets are. In accounting, depreciation ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  2. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  3. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  4. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  5. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  6. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
Trading Center