There are several methods which help us decide the value or price of a stock/business. All the financial and economic aspects are taken into consideration. Growth rates, rate of discount and expected returns from a stock are estimated. It is always better to consider few methods to arrive at a conclusion about a stock rather than going for a single method. The reason being every method has its own pros and cons.
Before we get down to valuing stocks in detail you need to be clear with various terms like WACC, NPV, Cost of Capital, Beta, Cost of Equity, IRR, etc.
Here is a brief about the various methods. It would be discussed in detail separately.
Two Methods
Absolute Valuing – i.e. finding the Intrinsic Value
Relative or Comparable valuing method
Absolute Valuation Method:
· Discounted Dividend Model (DDM)
It is also known as Gordon Model. Dividend is an actual cash flow paid to shareholders annually. The estimated future dividends are discounted to the present value to arrive at a stock price. This method can’t be used for all companies. To use DDM, a company must be consistent in its dividend payment and earnings which is possible in Blue chips or fundamentally highly rated companies. It uses Cost of Equity to discount the dividend cash flows.
· Discounted Cash Flow (DCF)
It is one of the most widely used methods. In this we calculate the present value of all future cash flows of the company. If a company is irregular in dividend payment they can opt for this method. It uses WACC to discount the cash flows.
· Residual Income Method
This method is not much popular. Residual Income in this context means deducting the expected returns for equity shareholders from the Net Income. This shows how much of income would be left if Net Income is directly distributed to the owners. The residual income for future is calculated and then discounted at the expected rate of return to arrive at the present value of the stock/business. It uses Cost of Equity to discount the Residual Income.
· Asset Based Valuation
This is not much preferred method. The assets are valued against the market value. If the book value shows a lower value than the market then it is considered good and not over valued as no investor likes to pay more for a company which has no market standing. It gets difficult to value the intangible assets and at times some company inflate their Goodwill which is very difficult to value as there is no exact value. Liabilities and Shares are deducted from the Assets valued.
Relative or Comparable Valuation Method:
This method involves comparing the various ratios or parameters of different companies of the same sector involved in similar activities. The Market capitalisation would be compared.
Various Ratios especially Price Earnings Ratio (P/E), Price to Book Value (P/BV), Price to Cash Flow (P/CF), Liquidity Ratio, Debt Turnover Ratio, etc are compared. It is much easier to calculate than the Absolute method as most of the elements to calculate are available to us from the company. Comparing variables also help us to know how a particular company is performing compared to all its competitors.
As there is no fool proof way to estimate the value, analysts always prefer to mix various methods and arrive at n conclusion. As past data doesn’t always seems to be the exact for future but yet it goes a long way.
D.V.P
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