Stock Valuation Models to Know for Intro to Investments

Stock valuation models help determine a company's worth by analyzing various financial metrics. These models, like the Dividend Discount Model and Price-to-Earnings Ratio, are essential tools in corporate finance and investment analysis for making informed decisions.

1. Dividend Discount Model (DDM)

   • Values a stock based on the present value of its expected future dividends.
   • Assumes dividends will grow at a constant rate indefinitely.
   • Useful for valuing companies with a stable dividend payout history.

2. Gordon Growth Model

   • A specific type of DDM that assumes a constant growth rate for dividends.
   • Formula: Price = D1 / (r - g), where D1 is the expected dividend, r is the required rate of return, and g is the growth rate.
   • Best suited for mature companies with predictable dividend growth.

3. Free Cash Flow to Equity (FCFE) Model

   • Calculates the cash available to equity shareholders after all expenses, reinvestments, and debt repayments.
   • Focuses on the company's ability to generate cash rather than just profits.
   • Useful for valuing companies that do not pay dividends.

4. Price-to-Earnings (P/E) Ratio

   • Compares a company's current share price to its earnings per share (EPS).
   • Indicates how much investors are willing to pay for $1 of earnings.
   • High P/E may suggest overvaluation or growth expectations, while low P/E may indicate undervaluation.

5. Price-to-Book (P/B) Ratio

   • Compares a company's market value to its book value (assets minus liabilities).
   • A P/B ratio less than 1 may indicate that the stock is undervalued.
   • Useful for assessing companies with significant tangible assets.

6. Discounted Cash Flow (DCF) Model

   • Estimates the value of an investment based on its expected future cash flows, discounted back to their present value.
   • Requires estimating future cash flows and determining an appropriate discount rate.
   • Widely used for valuing companies with varying cash flow patterns.

7. Comparable Company Analysis

   • Involves valuing a company based on the valuation multiples of similar companies in the same industry.
   • Common multiples include P/E, EV/EBITDA, and P/B ratios.
   • Provides a market-based perspective on valuation.

8. Asset-Based Valuation

   • Values a company based on the net value of its assets, both tangible and intangible.
   • Useful for companies with significant physical assets or in liquidation scenarios.
   • May not reflect the true earning potential of the business.

9. Residual Income Model

   • Values a company based on the income generated above the required return on equity.
   • Focuses on the profitability of a company after accounting for the cost of capital.
   • Useful for assessing companies with fluctuating earnings.

10. Earnings Multiplier Model

    • A variation of the P/E ratio that uses a multiplier to project future earnings based on current earnings.
    • Helps in estimating the future value of a company based on its earnings growth potential.
    • Useful for comparing companies with different growth rates.