Major Categories of Equity Valuation Models | CFA Level I Equity Investments

Before we dive into the various equity valuation models, let’s have a quick overview of the three major categories of such models.

In the last lesson, we discussed the intrinsic value of a stock and how analysts use valuation models to estimate it. There are a variety of models that can be used, and analysts usually employ more than one model with several different sets of inputs to determine a range of possible intrinsic values.

The valuation models can be broadly classified into three main categories: present value models, multiplier models, and asset-based valuation models.

1. Present Value Models

Present value models, or discounted cash flow models, estimate the intrinsic value as the present value of the future benefits expected to be received from the stock. Such benefits can be in terms of expected future dividends or free cash flow to equity, which is the cash flows available to be distributed to shareholders.

The Gordon growth model is one example of the dividend discount model, where the dividend is assumed to grow at a constant rate. A more complex model, which separates the growth into two stages, is known as the two-stage dividend discount model.

2. Multiplier Models

Multiplier models are very different from present value models in that they are based on relative valuation. A fair value multiple is derived from the multiples of a company’s peers and used to determine an intrinsic value for the company’s shares. There are two basic approaches:

• Share price multiples: A share price multiple is the ratio of the stock price to a fundamental, such as earnings, sales, book value, or cash flow per share. For example, if the fair value multiple of the firm’s peers is 12 times price to earnings, this multiplier is multiplied to the firm’s earnings to obtain an intrinsic value for its shares.
• Enterprise value multiples: This type is based on the ratio of enterprise value to either EBITDA or revenue. Enterprise value is the market value of all the firm’s outstanding securities minus cash and short-term investments, so what we are valuing here can include the firm’s debt and preferred stock. For example, if the fair value EV over EBITDA is 20 times, we can use this to calculate the fair value of the firm’s enterprise value and subtract the value of debt and preferred stock to get the intrinsic value of the common stock.

3. Asset-based Valuation Models

Under asset-based valuation models, the analyst estimates the value of all the assets of the firm. This is done by adjusting the book value of the assets to their fair value. Likewise, the values of the firm’s liabilities are adjusted. The intrinsic value of the common stock is therefore the total value of the assets, minus all liabilities, and the value of the firm’s preferred stock.

These are the three major categories of equity valuation methods. We will go through each of them for the rest of the course, so don’t worry if you still have questions at this point. We’ll start with present value models next.