Common Valuation Methodologies

In the world of investing, there is no 'one size fits all' approach to analyse a security. However, keeping your eye on a few valuation models and fundamental metrics could be a good starting point in assessing the attractiveness of stock. In this article, we take a closer look at some of the common valuation models – the discounted cash flow model, the dividend discount model, and valuation multiples – used to assess the valuation of a stock.

Discounted Cash Flow Model

The discounted cash flow (DCF) model is a valuation method used to evaluate the attractiveness of a stock, by using forecasts for future free cash flows and discounting them to arrive at a present value, which is then compared against a stock's current market price to evaluate its investment potential. This is the formula to calculate a stock's intrinsic value using the discounted cash flow model:

PV = FCF₁ / (1+k) + FCF₂ / (1+k) ² + … + FCF_n / (1+k) ⁿ

Where PV = present enterprise value, FCF = free cash flow, r = discount rate

Step 1: The first step of valuing a stock under this method is to estimate the future free cash flows that the underlying company is going to generate. As free cash flow is calculated by deducting capital expenditure from operating cash flow, one way to project future free cash flows is to estimate operating cash flows and expected capital expenditures over the next few years (e.g. ten years). Alternatively, if a company's growth in free cash flow has been rather consistent, its historical growth rate can be used, although caution should be exercised when using this method to extrapolate future cash flows, as a high growth rate now may not be sustainable in the future. In such cases, investors will have to adjust the growth rate accordingly.

Step 2: A dollar today is worth more than a dollar in the future because money is subjected to inflation, and can be invested today to earn interest over time. To account for the time value of money, the projected free cash flows should be discounted to determine their present value using an appropriate discount rate. Fundsupermart's stock intrinsic value calculator uses the widely used capital asset pricing model to derive a suitable discount rate.

Step 3: Sum up all the present values of projected future free cash flows to arrive at an estimate of a company's present enterprise value. Divide this value by the total number of outstanding common shares to compute the intrinsic value of a stock. If its intrinsic value is higher than its current market price, the stock is undervalued.

Discounted cash flow models are powerful tools, but they have their shortcomings too. Accurate free cash flow projections are hard to achieve, especially with longer forecast horizons. As such, investors should ensure that the intrinsic values derived using this valuation method give them a comfortable margin of safety to minimise any assumption errors made in the free cash flow projections. Investors should also complement the discounted cash flow model with other valuation approaches to gain a more complete picture of a stock.

Dividend Discount Model

Similar to the discounted cash flow model, the dividend discount model is a stock valuation method that seeks to estimate the intrinsic value of a stock by discounting future cash flows back to arrive at a present value. However, instead of free cash flows, the model uses expected future dividend payments as inputs. Consequently, this model is not suitable for valuing stocks that do not pay a dividend, or pay irregular dividends. To calculate a stock's intrinsic value using the dividend discount model, investors can use the following formula:

Intrinsic Value = D₁ / (k – g)

Where D₁ = dividends next year, k = discount rate, g = dividend growth rate

This method, also known as the Gordon Growth Model, assumes that a company exists forever and pays dividends that increase at a constant rate. The 'infinite' series of future dividend payments are then discounted back into the present using an appropriate discount rate, which can be derived using the capital asset pricing model. An investor needs to first estimate the expected dividend payments for next year, and divide this amount by the different between the discount rate and expected dividend growth rate, which can be estimated using historical dividend payments (although the individual investor should assess whether future dividend payments are sustainable). If the intrinsic value calculated from this valuation method is higher than its current market price, the stock is considered undervalued.

Valuation Multiples

The multiples method of stock valuation uses financial ratios from an industry, peer group or similar companies to estimate the value of a stock. Some of the commonly used ratios include, price-to-earnings ratio, price-to-book ratio and earnings-to-EBITDA (earnings before interest, tax, depreciation and amortisation), and they are also known as valuation multiples. The prevailing concept behind the multiples method of stock valuation is the law of one price, which states that similar assets should sell at a similar price. These ratios provide us with a yardstick to gauge the valuation of a company when compared against its industry, peer group or similar companies. For instance, a company with a low price-to-earnings ratio relative to its peers may be an indication that it is undervalued, although investors should note that comparing the ratios of companies in different industries to determine their relative attractiveness can be misleading as they can have very contrasting characteristics and fundamentals. While these ratios should not be a definitive guide for any investment decision, they remain useful valuation metrics that should not be used in isolation.