Major Categories of Equity Valuation Models

There are three major categories of equity valuation models: present value models, multiplier models, and asset-based valuation models.

Present Value Models/Discounted Cash Flow Models

These models estimate intrinsic value based on expected future benefits, usually based on expected dividends (dividend discount model) or expected free cash flows (free-cash-flow-to-equity models).

Multiplier Models/Market Multiple Models

These models are based on share price multiples or enterprise value multiples. Share price multiples usually calculate the intrinsic value based on the absolute or relative multiples of trailing or projected earnings or sales. Instead of using the share price in the numerator, enterprise value multiples use the company’s enterprise value (Market capitalization + Market value of debt and preferred shares – Cash equivalents) and typically divide it by EBITDA (EV/EBITDA) or total revenue (EV/Sales).

Asset-Based Valuation Models

These models estimate intrinsic value based on the estimated value of a company’s assets minus its liabilities, often through adjustments to its book value. In theory, the value of a business should be equal to the sum of the value of the business’s assets.

Question

At the beginning of 2016, stocks in the air transport industry had a trailing price-to-earnings ratio of approximately 12. An analyst believes that Fly2U, a publicly-traded air transport company, is undervalued primarily because its shares are trading at only 8 times trailing earnings.

The analyst is primarily using what type of model to estimate Fly2U’s share value?

1. Multiplier.
2. Asset-based.
3. Present value.

Solution

The correct answer is A.

The analyst in this scenario is primarily using a valuation model based on the price-to-earnings (P/E) ratio. The P/E ratio is a multiplier that relates a company’s stock price to its earnings per share. In this case, the analyst is comparing Fly2U’s P/E ratio (8 times trailing earnings) to the industry average (12 times trailing earnings) to argue that Fly2U may be undervalued.