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Basics of Common Stock Valuations

Deconstructing the Complex Techniques of Valuing Common Equity

Dec 15, 2007

A Little Bit of Math Never Hurt Anyone, stock.xchng

There are two general approaches to valuing common equity: 1) the discounted cash flows approach, and 2) the relative valuation approach.

Valuating common stock is a complex process, but certainly worth the trouble for both investors and analysts. Over the years, two general approaches have been developed, whereby one method estimates the stock’s value based on the present value of its future cash flows, such as dividends, operating cash flows or free cash flows, while the other method values a stock based on its current price relative to certain variables, such as the company's earnings, revenues or book value.

Common Factors in All Asset Valuations

Both the discounted cash flow approach and the relative valuation approach have certain factors in common. To start, both techniques are extensively impacted by the investor’s required rate of return, because this rate is essentially the discount rate used in many valuation models.

In addition, all asset valuation techniques are influenced by the estimated growth rate of certain variables, such as dividends, earnings, cash flows or sales. As already explained when discussing market efficiency, these variables must be estimated. This is also the reason why analysts using the same approach often arrive at different results.

When one of the variables has to be estimated, the end result varies because variable inputs are likely to differ from one analyst to another. In other words, when evaluating a stock, prices are likely to be different because investors’ required rates of return might be different, as well as because estimates of growth rates of dividends, for example, might be different, too.

There is one more factor both approaches have in common: they should be perceived as complementary to each other, and not as competitive approaches. Consequently, investors would be wise to understand the basic premises of both.

The Discounted Cash Flow Method

For most analysts, discounted cash flow methods are the very essence of valuation because the resulting cash flows from an investment are the most obvious measure of how successful (or not) the investment has proved itself to be.

The simplest or the “cleanest” method is to use dividends as cash flows because dividends go directly to the investor. This method implies that as a discount rate, analysts should use the cost of equity. One method of calculating the cost of equity is by using the capital asset pricing model (CAPM).

The only problem with using dividends as a measure of cash flows is in case of companies which do not pay dividends regularly or at all. On the other hand, the advantage of the dividend discount model (DDM) is its application when valuating established, mature companies where it is relatively safe to assume that dividends will be paid regularly and have a steady rate of growth.

The Relative Valuation Methods

When compared to discounted cash flow methods, the relative valuation methods are not bound in accuracy by how much estimated inputs reflect the current investment environment. More specifically, the relative valuation techniques incorporate relevant information with respect to how the market itself is valuating a security.

That’s the good news. The bad news is that the information provided is current in nature. Meaning, relative valuation will tell us how the market is pricing an asset currently, but it will provide little to no guidance as to the appropriateness of the valuation beyond the current point in time. After all, all securities can be undervalued or overvalued at any specific point in time. But whether those valuations could/would stand the test of time; that is an entirely different story.

For example, an analyst may be valuating a telecom stock and is using the industry valuation as the benchmark. Her analysis proves the stock is undervalued relative to its industry and she issues a buy recommendation. However, the analyst fails to test whether the benchmark she used was overvalued or undervalued. As it turns out, the benchmark was grossly overvalued; meaning, the analyst’s undervalued stock within the context of its industry proved to be rather overvalued when compared to the full breath of the market.

Investors should consider relative valuation methods, such as price-to-earnings, price-to-sales, price-to-book value and other similar ratios only when the overall market and the company’s industry are not at their extremes.

The copyright of the article Basics of Common Stock Valuations in Investment is owned by Inya Ivkovic. Permission to republish Basics of Common Stock Valuations in print or online must be granted by the author in writing.