Valuing equity securities
There are different ways to value an equity security - some are straightforward while others require more work. One can easily be overwhelmed by the number of valuation methods but you can split them into 2 categories: absolute valuation and relative valuation.
Absolute valuation aims to calculate the “intrinsic value” of a company based on projections and assumptions about the future performance of a company. This method looks at company fundamentals, such as dividends, growth rate and cash flow, to determine the true value of a company. However, a company does not always trade around its intrinsic value due to factors like momentum and macroeconomics. For example, AliBaba, one of the world’s largest online commerce companies, is fundamentally valued at a much higher price than the share price it is currently trading at. This is because the company is facing pressure from the government and this causes uncertainty about the future performance of the company.
Dividend discount model - the price of a stock is equal to the next year’s dividend divided by the difference between the cost of equity and constant growth rate.
Discounted cash flow - calculates the sum of the present value of all expected future cash flows, discounted at the weighted average cost of capital to determine the enterprise value of a company and eventually its stock price.
Residual income model - the price of a stock is equal to the present value of future residual flows discounted at the cost of equity.
Asset-based model - calculates the net asset value of a company based on the difference between the market value of its assets and liabilities.
As the title says, these methods value a company based on the valuation of similar companies in the same industry. This involves calculating ratios and multiples for several companies and then comparing them to each other. An example of a ratio is the price-to-earnings ratio(P/E) which measures its current share price relative to the earnings per share (EPS). For example, Ford’s P/E ratio is 16.00 but General Motors P/E ratio is only 5.91. This indicates that General Motors, relative to Ford Motor Company, is undervalued. This method of comparing ratios is much quicker and easier than any of the absolute valuation methods.
When analyzing an equity, the best way to start is by seeing the relative valuation of your company versus its comparables. If you want to take it step further, then use an absolute valuation method to estimate the intrinsic value and share price of your company.