Many analysts use more than one type of model to estimate value. Analysts recognize that each model is a simplification of the real world and that there are uncertainties related to model appropriateness and the inputs to the models. The choice of model(s) will depend on the availability of information to input into the model(s) and the analyst’s confidence in the information and in the appropriateness of the model (s).
Equity Valuation Models
Three major categories of equity valuation models are as follows:
- Present value models (synonym: discounted cash flow models). These models estimate the intrinsic value of a security as the present value of the future benefits expected to be received from the security. In present value models, benefits are often defined in terms of cash expected to be distributed to shareholders (dividend discount models) or in terms of cash flows available to be distributed to shareholders after meeting capital expenditure and working capital needs (free-cash-flow-to-equity models).
- Multiplier models (synonym: market multiple models). These models are based chiefly on share price multiples or enterprise value multiples. The former model estimates intrinsic value of a common share from a price multiple for some fundamental variable, such as revenues, earnings, cash flows, or book value. Examples of the multiples include price to earnings (PIE, share price divided by earnings per share) and price to sales (PIS, share price divided by sales per share). The fundamental variable may be stated on a forward basis (e.g., forecasted EPS for the next year) or a trailing basis (e.g., EPS for the past year), as long as the usage is consistent across companies being examined. Price multiples are also used to compare relative values. The use of the ratio of share price to EPS – that is, the PIE multiple-to judge relative value is an example of this approach to equity valuation.
- Enterprise value (EV) multiples have the form (Enterprise value) / (Value of a fundamental variable). Two possible choices for the denominator are earnings before interest, taxes, depreciation, and amortization (EBITDA) and total revenue. Enterprise value, the numerator, is a measure of a company’s total market value from which cash and short term investments have been subtracted (because an acquirer could use those assets to pay for acquiring the company). An estimate of common share value can be calculated indirectly from the EV multiple; the value of liabilities and preferred shares can be subtracted from the EV to arrive at the value of common equity.
- Asset-based valuation models. These models estimate intrinsic value of a common share from the estimated value of the assets of a corporation minus the estimated value of its liabilities and preferred shares. The estimated market value of the assets is often determined by making adjustments to the book value (synonym: carrying value) of assets and liabilities. The theory underlying the asset-based approach is that the value of a business is equal to the sum of the value of the business’s assets.
The above models are the most popular asset valuation methods, however, each equity valuation methods has its advantages and disadvantages so it is important to make the right decision based on the assets features and types.