Valuation

Section: Equity Valuation Estimated study time: 45 minutes Content: Equity valuation involves estimating the intrinsic value of a company's shares to determine whether the market price represents a buying opportunity, a selling opportunity, or fair value. The three broad approaches to equity valuation are: (1) discounted cash flow (DCF) models, which value a company as the present value of future cash flows; (2) relative valuation (multiples-based), which compares the company to similar businesses; and (3) asset-based valuation, which focuses on the liquidation or replacement value of assets. Each approach has specific applications and limitations. DCF models are the theoretically sound approach but sensitive to assumptions; relative valuation is practical but requires identifying truly comparable companies; asset-based valuation is most appropriate for asset-intensive businesses or liquidation scenarios. The Dividend Discount Model (DDM) is the simplest DCF equity valuation model: the value of a stock equals the present value of all expected future dividends. For a constant growth perpetuity (Gordon Growth Model): V0 = D1 / (re – g), where D1 is next year's expected dividend, re is the required return on equity, and g is the sustainable growth rate. For example, a stock expected to pay a $2 dividend next year, with a required return of 10% and a growth rate of 5%, is worth $2 / (0.10 – 0.05) = $40. The sustainable growth rate g = ROE × retention ratio = ROE × (1 – payout ratio). The model is appropriate for stable, dividend-paying firms but less applicable to growth companies that pay no dividends or to firms with rapidly changing growth profiles. Price multiples are the most widely used valuation tools in practice due to their simplicity…