There are two basic methods of valuing equity stock: absolute evaluation and relative evaluation, these methods have its own advantages and disadvantages. Analysts and investors should make wise decisions on the techniques for the asset valuation.
Stock Valuation Overview
Because of the complexity and importance of valuing common stock, various techniques for accomplishing this task have been devised over time. These techniques fall into one of two general approaches: (1) the discounted cash flow valuation techniques, where the value of the stock is estimated based upon the present value of some measure of cash flow, including dividends, operating cash flow, and free cash flow; and (2) the relative valuation techniques, where the value of a stock is estimated based upon its current price relative to variables considered to be significant to valuation, such as earnings, cash flow, book value, or sales.
An important point is that both of these approaches and all of these valuation techniques have several common factors. First, all of them are significantly affected by the investor’s required rate of return on the stock because this rate becomes the discount rate or is a major component of the discount rate. Second, all valuation approaches are affected by the estimated growth rate of the variable used in the valuation technique—for example, dividends, earnings, cash flow, or sales.
Absolute Valuation Techniques
The most straightforward measure of cash flow is dividends because these are clearly cash flows that go directly to the investor, which implies that you should use the cost of equity as the discount rate. However, this dividend technique is difficult to apply to firms that do not pay dividends during periods of high growth, or that currently pay very limited dividends because they have high rate of return investment alternatives available. On the other hand, an advantage is that the reduced form of the dividend discount model (DDM) is very useful when discussing valuation for a stable, mature entity where the assumption of relatively constant growth for the long term is appropriate.
The second specification of cash flow is the operating free cash flow, which is generally described as cash flows after direct costs (cost of goods and S, G & A expenses) and before any payments to capital suppliers. Because we are dealing with the cash flows available for all capital suppliers, the discount rate employed is the firm’s weighted average cost of capital (WACC). This is a very useful model when comparing firms with diverse capital structures because you determine the value of the total firm and then subtract the value of the firm’s debt obligations to arrive at a value for the firm’s equity.
The third cash flow measure is free cash flow to equity, which is a measure of cash flows available to the equity holder after payments to debt holders and after allowing for expenditures to maintain the firm’s asset base. Because these are cash flows available to equity owners, the appropriate discount rate is the firm’s cost of equity.
Relative Valuation Techniques
a potential problem with the discounted cash flow valuation models is that it is possible to derive intrinsic values that are substantially above or below prevailing prices depending on how you adjust your estimated inputs to the prevailing environment. An advantage of the relative valuation techniques is that they provide information about how the market is currently valuing stock at several levels—that is, the aggregate market, alternative industries, and individual stocks within industries. Following this chapter, which provides the background for these two approaches, we will demonstrate the alternative relative valuation ratios for the aggregate market, for an industry relative to the market, and for an individual company relative to the aggregate market, to its industry, and to other stocks in its industry.
The good news is that this relative valuation approach provides information on how the market is currently valuing securities. The bad news is that it is providing information on current valuation. The point is, the relative valuation approach provides this information on current valuation, but it does not provide guidance on whether these current valuations are appropriate—that is, all valuations at a point in time could be too high or too low.
The relative valuation techniques are appropriate to consider under two conditions: 1. You have a good set of comparable entities—that is, comparable companies that are similar in terms of industry, size, and, it is hoped, risk. 2. The aggregate market and the company’s industry are not at a valuation extreme—that is, they are not either seriously undervalued or overvalued.