All methods here are not an exact science since most of them need some forecasting. And we can never for sure know what the future holds.
And not every method does work for any scenario, and the more of them you do on a single company, the fairer the valuation will be. Since often doing one is not enough to get a whole picture of the valuation.
When we talk about Stock Valuation Methods they are often separated into two categories.
Absolute Valuation - Use fundamentals to try to find the true value of the company.
Relative Valuation - Comparing those fundamentals to other companies in the same branch.
So you can say that Absolute Valuation is looking at the company to try and figure out the intrinsic value.
And Relative Valuation is comparing them to other companies.
Gordon Growth Model GGM
Most suited for companies that:
- Pay a dividend
- Have a long track record of paying dividends
- Good Dividend Payout Ratio
The GGM assumes that the company will pay out a dividend forever and at a steady rate which is not true. This method is not as good if the company does not pay a dividend.
Preferred to use this model on companies has paid out a dividend for years. Since it makes the calculations have fewer assumptions.
The Discount Rate is also known as Net Present Value. And it means that we as investors are looking for a return on our investment. Are you looking to get a 10% investment return on your investment, then that's your Discount Rate.
The Dividend Growth Rate can be hard to calculate. So this model works best if the dividend is somewhat predictable. There are different ways to try to calculate this since we never know for sure how much it will grow.
A popular way to estimate it is also to take the Return on Equity * Retention Ratio.
If a company paid out a $1 dividend 10 years ago and has been increasing it to $2 the yearly dividend growth rate should be about 7%.
1 * (Dividend Growth Rate)^10 = 2 and if we put it in an algebra calculator like this one we get a number around 1.07 which means increased by 7%
If Company A does pay out a dividend of $1 and we want and 10% Discount Rate and we predict a Dividend Growth Rate of 5% we arrive at 1/(0.1-0.05) = $20
This means according to this method the share price is valued at $20 and anything over that means that it’s overvalued. And should be sold and anything beloved means it's undervalued and should be bought.
Discounted Cash Flow Model
Most suited for companies that:
- Easy to find/calculate the future cash flow
- Expected to increase their cash flow
The idea of this method is that money today is worth more than money in the future. Because we can invest money today and hence make it more in the future.
If we have investments that are expected to double in 7 years. It should mean that every dollar you get now is worth twice as much as any money you get after 7 years.
So $1 is only worth it now and every dollar you get after 7 years is worth $0.5 because if you had $0.5 today it would be $1 after we invested it for 7 years.
Cash Flow is all the money that comes in as revenue and goes out as an expense. Essentially all the money that comes in and out.
Residual Income Model
Equity Capital is our equity as the owners. A company has lent money from a bank and the rest is our Equity Capital. It’s very like Book Value.
If a company liquidates the Equity Capital is what we as the shareholders should receive.
Cost of Equity is the return we want to receive for our investment. I like to think of this as our profit needs as the shareholders.
Cost of Equity = (Dividend Payout / Share Price) + Rate of Appreciation
The Rate of Appreciation is the price increase of the stock price. We can never predict it.
Net Income is the income after all expenses. So minus taxes, cost of goods sold, interest, and everything else the company has paid for.
Most suited for companies that:
- Have a lot of tangible assets
- Assets that are easier to sell
This method is pretty straightforward since all we do is see how much of the assets are in a company.
It’s very popular to look at the NAV at investment, bank & real estate companies. Since they can sometimes be sold under the NAV value. This is also known as having a NAV Discount.
It’s often simpler to subtract the intangible assets since they are often more incorrectly valued and harder to sell. And only focus on the tangible assets.
When the tangible assets are being used to calculate the NAV. We should be getting the Liquidation Value.
And that should mean that if the company liquidates and sells its assets we as the shareholders should get paid more than we bought the stock for.
The assets are sometimes hard to sell since there are fewer buyers out there. This means even though the company is selling for less than its NAV it can still depreciate in value till it gets sold.
So we can conclude that assets that are easier to get sold are better.
We can also conclude that buying a company for less than its NAV. Should protect us from the worst-case scenario which is the company liquidates.
Capital Asset Pricing Model (CAPM)
CAPM is supposed to measure the market risks. Diversification can remove some risk but not market risk.
Risk-Free Rate is the smallest return if the investment had no risk at all. Most people think of treasures and interest bank accounts.
Beta is the volatility compared to a benchmark. The market is 1 so 1.2 would mean 20% higher volatility than the market and 0.9 would mean 10% less correlation to the benchmark. The more is higher volatility that has a correlation to the benchmark. And less should mean less correlation.
The benchmark is number 1.
0 would mean no correlation.
-1 would mean an inverse correlation. Meaning if the benchmark goes up the company should be going down, and vice versa.
1+ Higher volatility and does have some correlation to the benchmark.
And most people the benchmark is going to be the market.
Less correlation could also mean it’s better for diversification.
Market Risk Premium = Expected Market Return - Risk-Free Rate
Market Risk Premium is in other words what we should get paid for the risk. By taking out the risk-free investment like savings in a bank account, treasury bonds, etc. We should get the premium we pay for the risk we take compared to the market.
Market Risk Premium = S&P 500 Expected Return - Treasury Bonds Expected Return
Sometimes you want to calculate the premium on other kinds of investments but these are some standard benchmarks.
The Comparables Model
And over several years so you see the average and what’s likely to happen in the future. One year's multipliers can sometimes be deceiving.
The hard part is to compare the right multiples. Because what’s good to look for in one company can be worthless to look for in another.
Very easy and fast to do so ideal for the first model to try. Or when you don’t want to waste so much time.