Summary of Equity Valuation Models | CFA Level I Equity Investments

Welcome back as we conclude this topic with a summary of the valuation models we have learnt.

Three Major Categories of Equity Valuation Models

The three major categories of equity valuation models are:

1. Present value models
2. Multiplier models
3. 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. We have learnt the dividend discount model and the FCFE model.

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, known as the two-stage dividend discount model, separates the growth in 2 stages.

Pros: Widely accepted in the analyst community, based on the fundamental concept of discounted cash flow.

Cons: Results are sensitive to input values, inputs like required return and growth rate must be estimated.

2. Multiplier Models

Multiplier models 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:

• Based on share price multiples
• Based on enterprise value multiples

Price multiples, like the P/E ratio, have historically been useful for predicting stock returns. The EV/EBITDA ratio is useful for comparing firms when earnings are negative.

Pros: Readily available from various media outlets, useful for comparing firms.

Cons: Multiples for cyclical firms may be greatly affected by economic conditions, different accounting methods can result in price multiples that are not comparable across firms.

3. Asset-Based Valuation Models

Under asset-based valuation models, the analyst estimates the fair value of all the assets and liabilities of the firm. The intrinsic value of the common stock is simply the total value of the assets, minus all liabilities, and the value of the firm’s preferred stock.

Pros: Can provide the floor value of a stock.

Cons: Fair value of a company’s assets are usually different from their book values, fair value is usually not disclosed and can be difficult to estimate.

Choosing the Right Valuation Model

The choice of a model requires an analyst who is familiar with the benefits and limitations of each model. In practice, analysts often use more than one valuation model to derive better confidence in their conclusions. In cases where the conclusions from different models contradict each other, the analyst has to make a judgement on which model is more appropriate for the subject company.