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: $100 million
Year 2 FCF: $110 million
Year 3 FCF: $125 million
Year 4 FCF: $140 million
Year 5 FCF: $155 million
Step 2: Calculate the Present Value (PV) of each cash flow
PV of Year 1 FCF: $100 / (1 + 0.10)^1 = $90.91 million
PV of Year 2 FCF: $110 / (1 + 0.10)^2 = $90.91 million
PV of Year 3 FCF: $125 / (1 + 0.10)^3 = $93.91 million
PV of Year 4 FCF: $140 / (1 + 0.10)^4 = $95.63 million
PV of Year 5 FCF: $155 / (1 + 0.10)^5 = $96.24 million
Sum of PVs: $90.91 + $90.91 + $93.91 + $95.63 + $96.24 = $467.6 million
Step 3: Calculate the Terminal Value (TV)
The TV represents the value of all cash flows beyond the projection period. It's calculated using the Gordon Growth Model on the final projected cash flow.
TV = (FCFlast year × (1 + g)) / (r − g) = ($155 × (1 + 0.03)) / (0.10 − 0.03) = $159.65 / 0.07 = $2,280.7 million
Step 4: Calculate the Present Value of the Terminal Value
PV of TV = $2,280.7 / (1 + 0.10)^5 = $1,416.1 million
Step 5: Sum it all up
Intrinsic Value = Sum of PVs of FCFs + PV of TV
Intrinsic Value = $467.6 + $1,416.1 = $1,883.7 million
If Tech Innovations Inc. has 100 million shares outstanding, its intrinsic value per share is $1,883.7 / 100 = $18.84. If the current stock price is only $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 per share, it's expected to grow at a constant 4% per year, and our required rate of return is 8%.
D1 = $2.00 × (1 + 0.04) = $2.08
Value = $2.08 / (0.08 − 0.04) = $2.08 / 0.04 = $52.00
According to this model, the intrinsic value of Steady Dividends Corp. is $52 per share.
2. Relative Valuation Models
Relative valuation models compare a company to its peers or competitors. This approach is often quicker and simpler than absolute models, as it relies on market multiples and ratios. The assumption is that similar companies should have similar valuation metrics.
A. Comparable Company Analysis (Comps)
This is one of the most widely used methods.
It involves selecting a group of publicly traded companies that are similar in business model, size, and industry. You then compare valuation multiples, such as the Price-to-Earnings (P/E) ratio, Price-to-Sales (P/S) ratio, or Price-to-Book (P/B) ratio, to see if the target company is trading at a discount or premium compared to its peers.
- P/E Ratio: Compares a company’s stock price to its earnings per share. A lower P/E ratio relative to its industry could signal an undervalued stock.
- P/S Ratio: Compares a company’s market capitalization to its total sales. This is especially useful for companies with low or no earnings, like early-stage tech firms.
- P/B Ratio: Compares a company’s market value to its book value (assets minus liabilities). It’s often used for valuing financial institutions or companies with a lot of tangible assets.
Example: Let's value "Future Tech Inc." (FTI) with an annual net income of $50 million. We select three comparable companies in the same sector.
| Company | Market Cap | Net Income | P/E Ratio (Market Cap/Net Income) |
| FTI (Target) | ? | $50M | ? |
| Comp A | $1.2B | $60M | 20x |
| Comp B | $2.0B | $80M | 25x |
| Comp C | $1.5B | $75M | 20x |
Step 1: Calculate the average P/E ratio of the comparable companies.
Average P/E = (20 + 25 + 20) / 3 = 21.67x
Step 2: Apply the average P/E to the target company's earnings.
Valuation = Average P/E × FTI's Net Income
Valuation = 21.67 × $50 million = $1,083.5 million
The calculated intrinsic value for Future Tech Inc. is roughly $1.08 billion.
B. Precedent Transaction Analysis
This method values a company by looking at the prices paid for similar companies in past mergers and acquisitions (M&A).
It’s more common in corporate finance and M&A advisory, as it gives a sense of the value a company could fetch in a sale.
Example: A competitor of Future Tech Inc. was recently acquired for 20x its EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). If FTI's EBITDA is $70 million, a precedent transaction valuation would be: Valuation = 20 × $70 million = $1,400 million, or $1.4 billion.
3. Asset-Based Valuation
This approach is less about future earnings and more about what the company is worth if it were to liquidate. It calculates a company’s value by summing the fair market value of its assets and subtracting its liabilities.
A Liquidation Value
This is the value of a company if it were to be shut down and its assets were sold off.
It’s often considered the “floor” for a company’s value, representing the minimum amount an investor could expect to receive. This method is most useful for companies in distress or for those with a lot of physical assets.
Example: Let's assume a manufacturing company, "Widgets Inc.," has the following on its balance sheet:
Assets:
Cash: $50M
Inventory (at liquidation value): $30M
Plant & Equipment (at liquidation value): $120M
Total Assets = $200M
Liabilities:
Accounts Payable: $20M
Debt: $80M
Total Liabilities = $100M
Calculation:
Liquidation Value = Total Assets - Total Liabilities
Liquidation 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.