If you are going to use a valuation method on a stock for the first time, you might be daunted by the number of techniques that you can use. There are simple, straightforward valuation methods, and there are complicated ones. The following are the most common valuation methods that you can use.
Absolute Valuation Models
Absolute valuation models try to find the intrinsic or “true” value of investments based only by fundamentals. Looking at fundamentals means that you would pay attention to stuff like dividends, cash flow, and growth rate of a single company.
Relative Valuation Methods
Relative valuation models, on the other hand, work by comparing the company to other similar companies. These methods require you to calculate multiples and ratios, such as price-to-earnings multiple, and comparing these to the multiples of similar companies.
Dividend Discount Model (DDM)
The dividend discount model, or DDM, is one of the most common absolute valuation models. The DDM determines the ‘true’ value of a company based on the dividends that the company pays to its shareholders.
The idea is that since dividends represent the actual cash flows going to the shareholder, valuing the present value of these cash flows should give you a value for much these shares should be worth.
Your first step, of course, is to know whether the company pays dividends. The second step is to know whether the dividend is stable and predictable. Companies that whip out stable and predictable dividends are usually mature blue-chip companies in well-developed sectors and industries.
Discounted Cash Flow Model (DCF)
If the company doesn’t pay dividends, you can check if it fits the criteria used in the discounted cash flow model or DCF. Rather than looking at dividends, this model uses the company’s discounted future cash flows to value the business.
The advantage of this model is that it can be used with a wide variety of firms that do not whip out dividend payments. Of course, you may also use this method on companies that do pay dividends.
This model has several variations. However, the most commonly used form is the TWO-Stage DCF model. In this approach, the free cash flows are estimated for five to ten years and then a terminal value is calculated to account for all the cash flows beyond the forecast period.
The first requirement is that the company has to have positive and predictable cash flow, with which you will find many small high-growth companies and non-mature firms will be excluded because of large capital expenditures.
The comparables model can be used when you are unable to value companies using other models, or if you just don’t like spending time with too many calculations.
This one doesn’t aim to find the ‘true’ value of a company. Rather, it compares the stock’s price multiple to a benchmark to determine if the stock is relatively undervalued or overvalued.
The comparables model can be used in nearly all situations and this is because of the vast number of multiples that can be used, like the price-to-earnings, price-to-book, price-to-sales, price-to-cash-flow, and many others.
Among these ratios, the P/E ratio is the most popular because it focuses on the earnings of the company, which is one of the main drivers of an investment’s value.