Equity Valuation

Valuation is a process of determining the fair market value of an asset. Equity valuation therefore refers to
the process of determining the fair market value of equity securities. Equity valuation is not simple. Equity
represents a partnership in business. As such, it represents an attempt to value cash flow which is
uncertain and unpredictable.
Equity valuation is the method of deriving the fair value of a company or its equity stock. There are mainly
two types of valuation methods:

Absolute Valuation Model – This method attempts to find the true value of a stock based only on
fundamentals such as dividends, cash flow and growth rate of the company. In this model the value of the
asset is derived only on the basis of characteristics of that asset. These models are generally known as
the “discounted cash flow” of the DCF models and widely used across the industry. There are several
types of discounted cash flow models which we will discuss:

 Discounted Dividend Models: Discounted dividend models are based on this assumption that
the shareholders of the firm are only entitled to its dividends. So, these models assume the
purchase price of the share as the initial negative cash outflow and after that assume that
dividends that will be received throughout the life of the firm are the positive cash flows. Based on
the dividends, it is decided whether an investment is worthwhile given its current market price.

 Discounted Free Cash Flow Models: The discounted free cash flow models different from the
discounted dividend models. These models look at the total cash flow that will accrue to the
company. After that, they subtract the amount that are owed to outside parties like government,
 bondholders etc. The balance amount is considered free cash flow to the firm. This is projected
for many years and then discounted to come up at the valuation of the firm.

 Discounted Residual Income Models: Discounted residual income models look at broader
concept of cash flows. They consider all the cash flows that accrue to the firm post the payment
to suppliers and other outside parties. Payments due to bondholders and preference
shareholders are also not subtracted from the total amount. Then residual cash flow discounted
to arrive at the valuation of the firm.

 Discounted Asset Models: Discounted asset model is slightly different valuation model. In this,
valuation is conducted based upon the market value of the assets that the company currently
owns. The present value of each asset of the firm is derived and then all the values of all the
assets are added up to arrive at a value for the entire firm. It can only be used for commodity
businesses which involve oil, coal or other such natural resources.

Relative valuation models – These are different from discounted cash flow models. In this model
company compares to other similar companies and typically involves calculating and comparing multiples
or ratios such as PE As, they do not value a firm or an asset based on what its intrinsic value is. Moreover
these models believe that the market may be wrong about a given stock.

In relative valuation models is to find a benchmark valuation. Let’s say, when we make an index of all the
stocks in the technical industry, we get a market price to earnings ratio of 25. This means that the market
assumes that each stock is worth approximately 25 times what its current earnings are.

Then take a look at a particular stock. We see that the stock of Yahoo Inc.is valued only at 17 times its
earnings even though the market is valued at 25 times its earnings. By studying the details of Yahoo’s
business we find legitimate reasons as to why it should be so undervalued. Moreover, if there is no cause
for the stock to trade at a lower P/E than the market, then we assume that this is a market anomaly and
that Yahoo shares are trading below their fair value, making them a good buying option.

There are several variations of relative valuation models as well. Instead of using price earnings ratio,
someone can use price to sales ratio, price to book value ratio, price to cash flow ratio or any number of
ratios.

Process of Conducting Equity Valuation

The process of equity valuation is long, subjective and difficult to understand. It is followed differently by
different individuals. As such, there is no pre-defined standard process. Equity valuation process consists
of 4 or 5 broad categories of steps that need to be followed. Its procedures maybe different but the
objectives are always the same. Every person conducting equity valuation, must account for these
parameters:

1. Know about the macroeconomic factors and the industry: As performance of every business
is influenced by the performance of the economy in general as well as the industry in which it
operates. Such as, before making an attempt to value a business, the macro-economic factors
must be accounted for.
2. Make a reasonable forecast of the company’s performance: Only extrapolation of the
company’s current financial statements does not constitute a good forecast. Forecast takes into
account how the company may change its scale of production of the forthcoming future. After
 that, it also takes into account how changes in this scale will affect the costs. Cost and sale does
not move in linear fashion. To come up with an accurate forecast, an analyst should require
intricate knowledge of the company’s business.
3. Find the appropriate valuation model: There are many valuation models available. As well as,
all these valuation models do not necessarily lead to the same conclusion. Hence, it is the
responsibility of the analyst to understand which model would be most appropriate given the type
and quality of data available.
4. Come up at a valuation figure based on the forecast: The next step is to apply the valuation
model and arrive with an exact numerical value. It may be a single estimated value or it could be
a range. Investors prefer a range so that they can clearly know about what their lower and upper
bounds for bidding should be.
5. Take decision based on the arrived valuation: Finally, the analyst has to give a buy, sell or
hold recommendation based on the valuation model and what analysis shows is the intrinsic
worth of the firm.