Stock Valuation

By: Matthew L. Kovach, Investment Analyst

Stock valuation can be a complex process of gathering and analyzing information in order to make investment decisions. Generally, stock valuation is categorized into two main types of models: absolute and relative. Absolute stock valuation relies on company financial information regarding cash flows, dividends, and growth rates and is routinely performed using present value models. Relative stock valuation deals with the comparison of one company’s stock with similar companies through the calculation of key financial ratios and is commonly implemented through the method of comparables. Additionally, the amount of available information that can be used in a valuation analysis is overwhelming (e.g., company financial statements, news articles, analyst ratings, macroeconomic variables, etc.), and the information gathered and how it is processed depends on both the method and purpose of the analysis. Therefore, an investor needs to combine art and science in order to select the appropriate model and filter the important information from the excessive noise.

Suppose Company XYZ is in the business of manufacturing widgets and they have just announced record-breaking profits for the year and Company XYZ. We currently are not allocating any funds to companies operating in the widget sector and would like to purchase shares of Company XYZ for the diversification benefits, but are unsure if the current market price of $100 per share is a good buy. We begin our analysis with an absolute stock valuation approach using a present value model.

Absolute Valuation – Present Value Models

Present value models follow a fundamental principle of economics that individuals forgo current consumption and invest in the expectation of future economic benefits. Individuals and companies may defer consumption and instead make investments because they expect to earn a return over the investment period. Therefore, the value of the investment should be equal to the present value of the expected future benefits. For investors, these economic benefits are in the form of cash flows received from the investment in a company’s common stock. The simplest present value model of stock valuation, the dividend discount model (DDM), states that if a company operates as a going concern (i.e., in perpetuity) and the investor requires a constant rate of return, then the intrinsic value of the company’s stock is present value of all future dividends discounted at the required rate of return. [1]

The DDM is particularly useful for stock valuation of dividend-paying companies that are in a mature growth phase with low sensitivity to the business cycle. In the case of Company XYZ, their financial information shows they have maintained a stable dividend policy over the last decade. If we can assume that future dividends will grow at the historical rate, the DDM approach calculates the intrinsic value of Company XYZ’s stock at $110 per share. Since the market price is less than what we calculated for the intrinsic price, we will buy shares of Company XYZ for our portfolio.

Now, let’s suppose Company XZY is a non-dividend paying company. The DDM is rather useless to estimate the intrinsic value of Company XYZ because they are a non-dividend paying company. In such instances, a discounted cash flow (DCF) model is preferred where it is assumed that a company’s ability to pay distributions is reflected in the ability to generate cash flow. Free-cash-flow-to-equity (FCFE), a measure of cash flow in each period that is available for distribution to common shareholders, is defined as the cash flow from operations less any investment in fixed capital plus net borrowing. Under the DCF approach, the intrinsic value of the company’s stock involves discounting the future value of the company’s FCFE by the required return on equity divided by the number of shares outstanding. [2]

Going back to Company XYZ, we estimate the value of firm is $1,100 and their financial information shows 10 shares of common stock outstanding. The DCF model calculates the intrinsic value at $110 per share, and again we purchase shares as the intrinsic value is above the market price.

In many present value models, such as the DDM and DCF, the required rate of return on a share must also be estimated and is frequently done so using the capital asset pricing model (CAPM). The CAPM states that the required rate of return is the sum of the risk-free rate, , plus the product of a measure of non-diversifiable risk, , and the market risk premium. The market risk premium, , is often represented as the expected return of the market in excess of the risk-free rate. [3]

Relative Valuation – Method of Comparables

Alternatively, the method of comparables aims to evaluate the relative value of a company’s stock using the price multiples of comparable companies subject to the economic principle of the law of one price: identical assets should sell for the same price. The term price multiple refers to a financial ratio that compares the market share price with another financial metric. The most commonly used multiples include the price-to-earnings (P/E), price-to-book (P/B), price-to-sales (P/S), price-to-cash flow (P/CF) and enterprise value-to-EBITDA (EV/EBITDA). Thus, the method of comparables seeks to evaluate whether a stock is fairly valued, undervalued, or overvalued in relation to a benchmark value of the multiple which include the multiple of a closely comparable stock or the average or median value for a comparable sector or industry. In our analysis of Company XYZ, their financial information forecasts forward earnings at $5 per share. The widget industry average P/E multiple is currently 21X implying that Company XYZ’s stock price should trade for $105 per share. Again, the current market of $100 per share is below the intrinsic value of $105 per share supporting our earlier analysis to buy.

While the calculations of present value models and the required rates of return are exact, there is no uniquely correct measure of intrinsic value. Analysts may agree on the modeling approach, but have differing views on the inputs to each component of the stock valuation process. Additionally, the method of comparables becomes challenging when determining what constitutes a truly comparable company. Here at Ascend Advisory Group, we combine the art and science to filter the abundance of information while applying the methods described above and many more to all of our investment making decisions.

KEY TERMS: absolute valuation, capital asset pricing model, discounted cash flow model, dividend discount model, free-cash-flow-to-equity, intrinsic value, law of one price, method of comparable, present value models, relative valuation