Equity Valuation Models: Categories, Advantages, and Disadvantages

The primary objective of every equity valuation model is to estimate a company’s intrinsic value as objectively as possible. The choice of model depends on:

• Whether expected returns come primarily from capital appreciation or income.
• The nature of the company or industry.
• The availability and reliability of valuation inputs.

The two main valuation approaches are:

• Absolute valuation: Estimates intrinsic value using the company’s expected cash flows (Present value models) or asset values (asset-based valuation models).
• Relative valuation: Estimates value by comparing the company with similar firms using price- or enterprise value-based multiples.

Absolute Valuation Approaches

Absolute valuation estimates a company’s intrinsic value using the company’s expected future economic benefits. Rather than comparing the company with competitors, the analyst values the business based on its expected future performance.

The value of any financial asset equals the present value of the future economic benefits (which include dividends, free cash flows, future sale proceeds, and liquidation value) expected to be received by investors.

Because these benefits occur in the future, they must be discounted to today’s value using an appropriate required return.

Present Value Models

They estimate the intrinsic value by discounting future cash flows at an appropriate discount rate.

The model depends on the cash flow being discounted. We will look at Dividend Discount Models and Free Cash Flow Models.

1. Dividend Discount ModelsThey estimate intrinsic value as the present value of all expected future dividends.
   

   These models are most appropriate for companies that pay regular dividends, have stable dividend policies, and have relatively predictable growth.

2. Free Cash Flow ModelsFree cash flow is the excess of operating cash flow over capital expenditures, and can take two main forms: Free Cash Flow to Equity (FCFE) and Free Cash Flow to the Firm (FCFF).
   

   $$ \text{Free cash flow to the firm (FCFF)} = \text{Cash Flow from operations} + \text{Interest expense} \times (1 – \text{Tax Rate}) – \text{Capital expenditures} $$

   
   

   $$ \text{Free cash flow to equity (FCFE)} = \text{Cash flow from Operations} – \text{Capital expenditures} + \text{Net debt issuance} $$

   
   

   , where; \( \text{Net debt issuance} = \text{Additional Borrowing} – \text{Debt Repayment} \)

   
   

   Free cash flow models are particularly useful for: firms whose dividend policy does not reflect earning power, companies that retain most earnings, and firms that pay little or no dividends.

Asset-Based Valuation Models

Asset-based valuation estimates company value using the value of its assets after deducting liabilities. This approach is most appropriate when asset values are readily observable, liquidation value is important, and the business derives most of its value from tangible assets. Absolute valuation offers several important advantages.

Advantages of Absolute Valuation Models

1. Independent Estimate of Value -Because valuation depends on company fundamentals rather than peer prices, it can identify situations where the entire market or industry is mispriced.
2. Fundamental Focus – These models focus on the drivers of value like expected cash flows, growth, and profitability; This allows analysts to understand why a company is valuable.
3. Applicable without comparable companies – Absolute valuation remains useful even when few comparable companies exist. This is especially important for unique businesses, firms operating in niche industries, and companies with unusual business models.

Limitations of Absolute Valuation

1. Forecast Risk -Future cash flows cannot be observed and must be forecasted. Errors in assumptions will affect the estimated intrinsic value.
2. Sensitivity to Assumptions -Small changes in growth rates, discount rates, or terminal value can lead to significant changes in the estimated intrinsic value.
3. Greater Complexity -Absolute valuation generally requires more data, more assumptions, and more modelling efforts than relative valuation.

Relative Valuation Approaches

Relative valuation estimates value by comparing a company with similar publicly traded companies. Relative valuation assumes that similar companies should trade at similar valuation multiples after adjusting for differences in growth, profitability, and risk. Therefore, the valuation of one company provides information about the valuation of another comparable company.

Relative Valuation Using Multiples

This approach compares valuation multiples such as Price-to-Earnings \((P/E)\), Price-to-Book \((P/B)\), Price-to-Sales \((P/S)\), and Enterprise Value multiples.

Advantages of Relative Valuation

1. Simple to Apply – Relative valuation requires fewer assumptions than discounted cash flow models.
2. Widely used – Investment professionals frequently use comparable company analysis because it is straightforward to communicate.
3. Reflects Current Market Conditions – Because it uses current market prices, relative valuation incorporates prevailing market expectations.

Limitations of Relative Valuation

1. Dependence on Comparable Companies – Relative valuation requires companies with sufficiently similar characteristics for comparison. If suitable comparables are unavailable, the valuation may be less reliable.
2. The quality of the valuation depends on selecting appropriate peer companies – The reliability of the valuation depends heavily on selecting appropriate peer companies. Differences in growth, profitability, and risk can make a comparison misleading.
3. Poor peer selection can lead to misleading conclusions – If an analyst selects inappropriate peers, the resulting valuation may give a false impression that a company is overvalued or undervalued.
4. Industry Mispricing – If an entire industry is overpriced or underpriced, relative valuation may incorrectly suggest that a company is fairly valued.
5. Market Dependence – Relative valuation cannot independently determine intrinsic value because it relies on current market prices. If the market or peer companies are mispriced, that mispricing can be incorporated into the valuation of the company being analyzed.

Reconciling Multiple Equity Valuation Approaches

Professional analysts rarely rely on a single valuation model. Instead, they estimate intrinsic value using several approaches and compare the results. Different models frequently produce different intrinsic value estimates. This disagreement is expected and does not necessarily indicate that one model is incorrect. When valuation estimates differ, analysts should investigate the reasons rather than simply averaging the results.

Reconciling these differences helps analysts gain greater confidence in their final valuation conclusion.

Selecting an Appropriate Valuation Model

The most appropriate model depends on the company being analyzed.

$$
\begin{array}{l|l}
\text{Company Characteristic} & \text{Appropriate Valuation Approach} \\
\hline
\text{Stable Dividend Payer} & \text{Dividend Discount Model} \\
\hline
\text{Predictable Cashflows} & \text{Discounted Cash Flow} \\
\hline
\text{No dividends but positive cash flows} & \text{Free Cash Flow Model} \\
\hline
\text{Asset-intensive Company} & \text{Asset-Based Valuation} \\
\hline
\text{Many Comparable Firms} & \text{Relative Valuation} \\
\end{array}
$$

Professional analysts frequently apply more than one model before making an investment recommendation.

Using Multiple Valuation Models

Analysts should compare valuation results obtained using different approaches.

Agreement among several valuation methods generally increases confidence in the estimated intrinsic value. Conversely, large differences signal that further analysis is required before reaching an investment decision.

Question

A junior analyst values a company using a discounted cash flow model and estimates an intrinsic value of $56 per share. A second analyst applies a comparable company analysis and estimates a value of $49 per share.

The portfolio manager concludes that the company is worth approximately $52 per share without investigating why the two estimates differ.

The portfolio manager’s approach is least appropriate because:

1. different valuation models should produce identical estimates if applied correctly.
2. relative valuation models should never be used together with absolute valuation models.
3. analysts should reconcile the assumptions underlying different valuation models before drawing a valuation conclusion.

Solution

The correct answer is C.

Different valuation models naturally produce different estimates because they rely on different assumptions, inputs, and methodologies. Rather than simply averaging or selecting a value, analysts should investigate why the estimates differ and reconcile the underlying assumptions before reaching a final valuation conclusion.

A is incorrect. Different models are expected to produce different values.

B is incorrect. Analysts commonly use both absolute and relative valuation approaches together to improve confidence in their conclusions.