3 Different Methods of Equity Valuation

Assets:

Cash: $50M   Inventory (at liquidation value):$ 30M

Plant & Equipment (at liquidation value): $120M   <strong>Total Assets =$ 200M

Liabilities:

Accounts Payable: $20M   Debt:$ 80M

Total Liabilities = $100M</strong> </div> </div>   <pre class="wp-block-verse"><strong>Calculation:</strong>Liquidation Value = Total Assets - Total LiabilitiesLiquidation Value =$ 200M – $100M =$ 100M

The liquidation value of Widgets Inc. is $100 million. This represents a “floor” for its valuation, as this is what shareholders could theoretically receive in a shutdown.

Final Thoughts

As you can see, no single valuation method is perfect.

Each has its strengths and weaknesses, and the best analysts use a combination of these techniques to arrive at a more robust valuation range. For example, a DCF model might provide a theoretical value based on future growth, while a comparable company analysis provides a reality check against current market sentiment.

The key takeaway is to look beyond the current share price. By understanding the intrinsic value of a company, you can make more informed, rational investment decisions and potentially uncover great opportunities that the rest of the market has overlooked.

You don’t just buy a stock based on its current price, do you? Wise investors know that a company’s market price can be influenced by all sorts of things, from market sentiment to temporary news cycles. The real question is: Is the stock’s price reflective of its actual worth? This is where equity valuation comes in.

It’s the process of determining the “intrinsic value” of a company’s stock—what it’s really worth based on its fundamentals, not just its current trading price. By understanding a stock’s intrinsic value, you can decide whether it’s a bargain (undervalued), overpriced (overvalued), or fairly priced, which is the cornerstone of successful, long-term investing.

Here are the most common ways investors and analysts value stocks.

1. Absolute Valuation Models

Absolute valuation models, also known as intrinsic valuation, attempt to determine a company’s value on its own, without referencing other companies. They are based on the idea that the value of an asset is the present value of all its future cash flows.

A. Discounted Cash Flow (DCF) Model

This is arguably the most comprehensive valuation method.

The DCF model projects a company’s future cash flows—the cash a business generates from its operations after accounting for capital expenditures—and then discounts them back to their present value using a “discount rate” that reflects the risk of the investment. A stock is considered undervalued if its calculated DCF value is higher than its current market price.

The DCF model projects a company’s future cash flows and then discounts them back to their present value using a “discount rate” (typically the Weighted Average Cost of Capital, or WACC) that reflects the risk of the investment.

Example: Let's value "Tech Innovations Inc." with a WACC of 10%. We project its Free Cash Flow (FCF) for the next five years and assume a terminal growth rate of 3% beyond that.

Step 1: Project Future Cash Flows

Year 1 FCF: 110 million
Year 3 FCF: 140 million
Year 5 FCF: 100 / (1 + 0.10)^¹ = 110 / (1 + 0.10)^² = 125 / (1 + 0.10)^³ = 140 / (1 + 0.10)^⁴ = 155 / (1 + 0.10)^⁵ = 90.91 + 93.91 + 96.24 = 155 × (1 + 0.03)) / (0.10 − 0.03) = 2,280.7 million

Step 4: Calculate the Present Value of the Terminal Value

PV of TV = 1,416.1 million

Step 5: Sum it all up

Intrinsic Value = Sum of PVs of FCFs + PV of TV

Intrinsic Value = 1,416.1 = 1,883.7 / 100 = 15, the stock may be undervalued.

B. Dividend Discount Model (DDM)

This model is a variation of the DCF model, but it focuses specifically on the dividends a company is expected to pay to its shareholders.

It calculates a stock’s value as the present value of its future dividend payments. This method is best for mature, dividend-paying companies with a history of consistent dividend growth, as it’s not suitable for non-dividend-paying stocks.

The DDM is a variation of the DCF model, but it focuses on dividends instead of free cash flow. It’s most suitable for stable, mature companies with a history of consistent dividend payments. The Gordon Growth Model is a common version of the DDM. The formula is:

Value = D₁ / (r − g)

Where:

D₁: Expected dividend per share next year

r: Required rate of return (or discount rate)

g: Expected constant growth rate in dividends

Example: Let's value "Steady Dividends Corp." Its last dividend was 2.00 × (1 + 0.04) = 2.08 / (0.08 − 0.04) = 52.00

According to this model, the intrinsic value of Steady Dividends Corp. is 50 million. We select three comparable companies in the same sector.