Equity Valuation Concepts
Equity valuation involves estimating the value of a company by estimating its future cash flows, considering its risk level, and then discounting them to their present value. Equity valuation typically requires information such as the company's financial statements, historical returns, and any reported risks. This information can then be used to estimate the company's future cash flows and determine its equity value.
Discounted Cash Flow Valuation:
Discounted cash flow (DCF) valuation is a method used to estimate the intrinsic value of an investment based on its future cash flows. This method takes into account the time value of money, which is the idea that a dollar received today is worth more than a dollar received in the future. This is because money has a certain level of earning potential, and the longer it is held, the more it can potentially earn.
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In a DCF valuation, the future cash flows of an investment are projected based on the expected performance of the investment. These cash flows are then discounted by a certain rate, which is known as the discount rate. The discount rate is used to reflect the time value of money as well as the level of risk associated with the investment. The lower the discount rate, the higher the present value of the future cash flows.
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The present value of the future cash flows is then calculated by discounting each future cash flow by the appropriate discount rate. The present value of the future cash flows is then used to estimate the intrinsic value of the investment. This value can be compared to the investment's current market value to determine whether it is overvalued or undervalued.
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For example, suppose an investor is considering purchasing a stock with an expected annual cash flow of $100 for the next five years. If the investor uses a discount rate of 10%, the present value of the future cash flows would be calculated as follows:
Year 1: $100 / (1 + 0.10)^1 = $90.91
Year 2: $100 / (1 + 0.10)^2 = $82.64
Year 3: $100 / (1 + 0.10)^3 = $75.13
Year 4: $100 / (1 + 0.10)^4 = $68.30
Year 5: $100 / (1 + 0.10)^5 = $62.09
The total present value of the future cash flows would be $90.91 + $82.64 + $75.13 + $68.30 + $62.09 = $389.08. This would be the intrinsic value of the investment according to the DCF model. If the stock's current market value is higher than its intrinsic value, the investor may decide not to purchase it because it is considered overvalued. On the other hand, if the stock's market value is lower than its intrinsic value, the investor may consider it to be a good investment because it is considered undervalued.
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In summary, DCF valuation is a method used to estimate the intrinsic value of an investment based on its future cash flows and the time value of money. It involves projecting the investment's future cash flows, discounting them by a certain rate, and then calculating the present value of the future cash flows to estimate the investment's intrinsic value. This value can then be compared to the investment's market value to determine whether it is overvalued or undervalued.
Dividend Discount Valuation:
Dividend discount valuation is a method used to determine the intrinsic value of a company's stock based on the assumption that its value is the present value of all of its future dividends. This method is based on the idea that the value of a stock is the sum of the present values of all of its future dividends.
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To use this method, an investor must first determine the expected future dividends for the company. These dividends can be based on the company's historical dividend payments, or they can be based on the investor's estimates of the company's future earnings and dividend payout ratio.
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Once the expected future dividends are determined, the investor can use a discount rate to calculate the present value of these dividends. The discount rate is a measure of the time value of money, and it reflects the idea that a dollar received in the future is worth less than a dollar received today.
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The present value of the future dividends is then subtracted from the current market price of the stock to determine whether the stock is undervalued or overvalued. If the present value of the future dividends is higher than the current market price, the stock is considered undervalued and may be a good buy. If the present value of the future dividends is lower than the current market price, the stock is considered overvalued and may not be a good buy.
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Overall, dividend discount valuation is a useful tool for investors who are looking for undervalued stocks with a track record of stable or growing dividends. It can help investors identify companies that may be worth buying and holding for the long term.
Relative Valuation:
Relative valuation is a method of equity valuation that looks at the value of a company relative to its peers. It involves comparing the financial parameters of one company against those of its peers or competitors. The parameters used for comparison can be market capitalization, price-to-earnings ratio, price-to-book ratio, price-to-sales ratio, return on equity, and other financial metrics. The idea is to look at how a company is valued compared to its peers. This method of valuation is often used by investors and analysts to decide if a company is undervalued or overvalued relative to its peers. It can also be used to compare a company’s performance against its peers, allowing an investor to identify potential investment opportunities.
For example:
1. Price-to-Earnings Ratio: Companies that are in the same industry can be compared by looking at their price-to-earnings ratio (P/E ratio). This ratio measures how much investors are willing to pay for each dollar of earnings. If a company’s P/E ratio is higher than its peers, it could indicate that the company is overvalued relative to its peers.
2. Price-to-Book Ratio: The price-to-book ratio (P/B ratio) compares a company’s market price to its book value. A high P/B ratio could indicate that a company is overvalued, while a low P/B ratio could indicate that it is undervalued.
3. Price-to-Sales Ratio: The price-to-sales ratio (P/S ratio) compares a company’s market price to its sales. Companies with a high P/S ratio could indicate that the company is overvalued, while a low P/S ratio could indicate that it is undervalued.
4. Return on Equity: Return on equity (ROE) is a measure of how well a company is generating profits from its equity. Companies with a higher ROE