Stock Valuation Methods

Why This Matters

Stock valuation sits at the heart of corporate finance—it's how analysts determine whether a company is worth buying, selling, or holding. You're being tested on your ability to select the right valuation method for a given scenario, understand the assumptions behind each approach, and recognize when one method gives a more reliable estimate than another. These concepts connect directly to capital markets, cost of capital calculations, and investment decision-making frameworks you'll encounter throughout the course.

The methods fall into two broad camps: intrinsic valuation (calculating what a stock should be worth based on fundamentals) and relative valuation (comparing what similar stocks are worth in the market). Mastering both approaches means understanding when each applies, what inputs drive the output, and how assumptions change the result. Don't just memorize formulas—know what each method assumes about growth, risk, and cash flows, and be ready to explain why you'd choose one over another.

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Intrinsic Valuation: Cash Flow-Based Methods

These methods estimate a stock's fundamental worth by projecting future cash flows and discounting them to present value. The core principle: a stock is worth the sum of all future cash it will generate for shareholders, adjusted for the time value of money and risk.

Discounted Cash Flow (DCF) Model

• Projects future free cash flows and discounts them to present value—the gold standard for intrinsic valuation because it's independent of current market sentiment
• Discount rate reflects risk; typically uses WACC for firm valuation or cost of equity for equity valuation
• Highly sensitive to terminal value assumptions—small changes in growth rate or discount rate dramatically shift the output

Free Cash Flow to Equity (FCFE) Model

• Calculates cash available to equity holders after debt payments and reinvestment—formula: $FCFE = Net Income - Net CapEx - \Delta Working Capital + Net Borrowing$
• Differs from FCFF by focusing specifically on what's left for shareholders, not all capital providers
• Best for companies with volatile capital expenditures where earnings don't reflect true cash generation

Dividend Discount Model (DDM)

• Values stock as present value of all expected future dividends—assumes dividends are the only relevant cash flow to shareholders
• Requires stable dividend policy to generate reliable estimates; fails for non-dividend-paying companies
• Formula for constant growth: $P_0 = \frac{D_1}{r - g}$ where $D_1$ is next year's dividend, $r$ is required return, and $g$ is growth rate

Gordon Growth Model

• Specific DDM variant assuming perpetual constant dividend growth—simplifies valuation to a single formula
• Growth rate must be less than discount rate ($g < r$) or the model breaks down mathematically
• Best suited for mature, stable companies like utilities or consumer staples with predictable dividend histories

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Intrinsic Valuation: Income-Based Methods

These approaches value companies based on their ability to generate returns above what investors require. The key insight: a company creates value only when it earns more than its cost of capital.

Residual Income Model

• Values stock based on income exceeding the required return on equity—formula: $RI = Net Income - (Equity \times Cost of Equity)$
• Works for non-dividend payers and companies with irregular cash flows where DCF inputs are unreliable
• Connects directly to EVA (Economic Value Added) concept—positive residual income means the company is creating shareholder value

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Relative Valuation: Earnings Multiples

Relative valuation compares a company's metrics to peers or market averages. The underlying logic: similar companies should trade at similar multiples, so deviations signal over- or undervaluation.

Price-to-Earnings (P/E) Ratio

• Compares share price to earnings per share—formula: $P/E = \frac{Price}{EPS}$; the most widely quoted valuation metric
• High P/E suggests growth expectations (investors paying premium for future earnings); low P/E may signal undervaluation or declining prospects
• Trailing P/E uses historical earnings; forward P/E uses projected earnings—know which one you're analyzing

Enterprise Value-to-EBITDA (EV/EBITDA) Ratio

• Compares total firm value to operating earnings—formula: $EV = Market Cap + Debt - Cash$; EBITDA strips out capital structure effects
• Capital structure neutral unlike P/E, making it ideal for comparing companies with different debt levels
• Lower ratios suggest better value, but always compare within industries—capital-intensive sectors naturally trade at different multiples

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Relative Valuation: Asset and Revenue Multiples

These ratios anchor valuation to balance sheet assets or top-line revenue rather than earnings. Useful when earnings are negative, volatile, or don't yet reflect the company's potential.

Price-to-Book (P/B) Ratio

• Compares market value to book value of equity—formula: $P/B = \frac{Price}{Book Value Per Share}$
• P/B below 1.0 may signal undervaluation relative to net assets, but could also indicate asset quality concerns
• Most relevant for asset-heavy industries like banks, insurance companies, and REITs where book value meaningfully reflects economic worth

Price-to-Sales (P/S) Ratio

• Compares stock price to revenue per share—useful when earnings are negative or distorted by accounting choices
• Cannot be negative (unlike P/E when earnings are negative), making it applicable to early-stage growth companies
• Lower P/S in growth sectors may indicate undervaluation, but always consider profit margins—high revenue means nothing without eventual profitability

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Relative Valuation: Peer Comparison

Comparable Company Analysis

• Derives value by applying peer multiples to the target company—select comparables by industry, size, growth profile, and risk
• Uses multiple valuation ratios (P/E, EV/EBITDA, P/S) to triangulate a fair value range rather than a single point estimate
• Reflects current market sentiment, which can be both a strength (market efficiency) and weakness (market irrationality)

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Quick Reference Table

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Self-Check Questions

1. A company pays no dividends and has highly variable capital expenditures. Which two valuation methods would be most appropriate, and why would DDM fail here?

2. Compare and contrast P/E ratio and EV/EBITDA. When would you prefer EV/EBITDA over P/E for comparing two potential acquisition targets?

3. The Gordon Growth Model requires that $g < r$. What happens mathematically if growth equals or exceeds the discount rate, and what does this imply about the model's applicability?

4. You're valuing a regional bank with substantial loan portfolios and real estate holdings. Which relative valuation metric is most appropriate, and why might P/S be misleading in this context?

5. An FRQ asks you to explain why two companies in the same industry could have identical P/E ratios but different intrinsic values under DCF. What factors would you discuss in your response?