Stock Valuation Models

Why This Matters

Stock valuation sits at the heart of corporate finance—it's how analysts, investors, and managers answer the fundamental question: What is this company actually worth? You're being tested on your ability to select the right model for the right situation, understand the assumptions each model makes, and recognize when those assumptions break down. This isn't just about plugging numbers into formulas; it's about understanding the conceptual logic behind why different approaches yield different values.

These models connect directly to core finance principles you'll see throughout the course: time value of money, risk-return tradeoffs, cost of capital, and market efficiency. Whether you're analyzing a mature dividend-paying utility or a high-growth tech startup that reinvests everything, you need to match the valuation approach to the company's characteristics. Don't just memorize formulas—know when each model applies and why it works (or doesn't) in different scenarios.

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Intrinsic Value Models: Discounting Future Cash Flows

These models estimate what a stock is actually worth based on the present value of cash flows the company will generate. They rely on the principle that a dollar today is worth more than a dollar tomorrow—so future cash flows must be discounted back to present value.

Dividend Discount Model (DDM)

• Values stock as the present value of all expected future dividends—assumes shareholders ultimately care about cash distributions they'll receive
• Requires stable, predictable dividend payments—works poorly for companies that don't pay dividends or have erratic payout policies
• Foundation for other intrinsic models—understanding DDM logic helps you grasp more complex cash flow approaches

Gordon Growth Model

• Simplifies DDM by assuming constant dividend growth forever—formula: $P_0 = \frac{D_1}{r - g}$ where $D_1$ is next year's dividend, $r$ is required return, and $g$ is growth rate
• Only valid when $r > g$—if growth exceeds required return, the formula produces nonsensical negative values
• Best for mature, stable companies—think utilities or consumer staples with decades of consistent dividend increases

Discounted Cash Flow (DCF) Model

• Discounts all expected future free cash flows to present value—more flexible than DDM because it doesn't require dividend payments
• Requires two critical estimates: future cash flows and the discount rate (WACC)—small changes in these assumptions dramatically shift valuations
• Industry standard for M&A and investment banking—when you hear "intrinsic value," analysts usually mean DCF

Free Cash Flow to Equity (FCFE) Model

• Measures cash available to shareholders after all obligations—calculated as operating cash flow minus capital expenditures minus net debt payments
• Captures true cash-generating ability, not accounting profits—a company can show positive earnings while burning cash
• Ideal for non-dividend-paying companies—lets you value firms that reinvest everything back into growth

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Relative Valuation: Market-Based Multiples

Rather than calculating intrinsic value, these approaches ask: What are similar companies trading for? They assume the market prices comparable firms reasonably well, so you can use those benchmarks to assess whether a stock is cheap or expensive.

Price-to-Earnings (P/E) Ratio

• Compares share price to earnings per share (EPS)—formula: $P/E = \frac{Price}{EPS}$, showing what investors pay for each dollar of earnings
• High P/E suggests growth expectations or overvaluation—low P/E may signal undervaluation or that the market expects declining earnings
• Most widely quoted valuation metric—you'll see this in virtually every equity research report and financial news article

Price-to-Book (P/B) Ratio

• Compares market value to book value (assets minus liabilities)—formula: $P/B = \frac{Market\ Price}{Book\ Value\ per\ Share}$
• P/B below 1.0 may indicate undervaluation—or it could signal the market expects asset write-downs or poor future returns
• Most useful for asset-heavy industries—banks, insurance companies, and manufacturers with significant tangible assets on the balance sheet

Comparable Company Analysis

• Values a company using multiples from similar public firms—common multiples include P/E, EV/EBITDA, and P/B ratios
• Requires identifying truly comparable companies—same industry, similar size, comparable growth rates and risk profiles
• Provides market-based reality check on intrinsic models—if your DCF says a stock is worth $100 but every comparable trades at $50, revisit your assumptions

Earnings Multiplier Model

• Projects future value using current earnings and a growth-adjusted multiplier—essentially a forward-looking P/E approach
• Useful for comparing companies with different growth rates—a high-growth firm deserves a higher multiplier than a no-growth firm
• Bridges relative and intrinsic approaches—incorporates growth expectations into a multiple-based framework

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Asset-Based and Residual Approaches: Alternative Frameworks

When cash flows are unpredictable or a company's value lies primarily in its assets rather than operations, these alternative models provide better answers.

Asset-Based Valuation

• Values company as net assets: total assets minus total liabilities—essentially asks "what would we get if we sold everything?"
• Ignores going-concern value and future earnings potential—a profitable business is worth more than its liquidation value
• Best for asset-heavy firms, holding companies, or bankruptcy analysis—also useful as a "floor" value in negotiations

Residual Income Model

• Values stock based on earnings above the required return on equity—formula: $Value = Book\ Value + \sum \frac{Residual\ Income_t}{(1+r)^t}$
• Residual income = Net Income − (Equity × Cost of Equity)—positive residual income means the company creates value beyond its capital cost
• Useful when earnings fluctuate but book value is stable—connects accounting data to economic value creation

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Quick Reference Table

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Self-Check Questions

1. A mature utility company has paid steadily increasing dividends for 30 years. Which two models would be most appropriate, and why might you prefer one over the other?

2. You're valuing a high-growth tech company that reinvests all profits and pays no dividends. Which models are appropriate, and which should you avoid?

3. Compare and contrast P/E ratio and P/B ratio: For what types of companies is each most useful, and what does a "low" value signal in each case?

4. If your DCF analysis values a stock at $80 but comparable company analysis suggests $50, what are three possible explanations for the discrepancy?

5. A company generates $10 million in net income on $100 million in equity, and its cost of equity is 8%. Calculate whether it creates or destroys value using the residual income framework, and explain what this means for shareholders.