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Equity valuation - An insight

Mar 29, 2007

The problem with equity valuation is not that there are not enough models to value equity, but that there are enough of them to confuse the investor. Selecting the right model to use in valuation is as critical as to arriving at a reasonable value. In this article, we take a look into two of the equity valuation approaches.

An important point is that both of these approaches and all of these valuation techniques have several common factors. First, all of them are significantly affected by investors required rate of return on the stock because this rate becomes the discount rate or is a major component of the discount rate. Secondly, all valuation approaches are affected by the estimated growth rate of the variable used in valuation techniques i.e. dividend, earnings, cash flow or sales. Due to this difference, an analyst using the same valuation techniques will derive different estimates of value of a stock because they have different estimates for the critical variable inputs.

Discounted Cash Flow Valuation (DCF)
The DCF valuation focuses on the firm's ability to generate cash over its entire lifetime and then discounting it back to the present value. The major difference between the alternative techniques is how one specifies the cash flow.

Cash FlowDiscount rate
Dividends -
they are the cash flow which goes directly to the investors
Cost of equity
Operating free cash flow -
Cash flow after direct costs are before any payment to capital providers
Weighted Average Cost of Capital
Free cash flow to equity -
Cash flow available to equity share holders after making payment
to debt holders and after allowing for expenditures to maintain the forms asset base
Cost of equity

Besides being theoretically correct, these models allow a substantial amount of flexibility in terms of changes in sales and expenses that implies changing growth rate over time. A potential difficulty with the DCF approach is that they are very dependent on two significant inputs -

  1. The growth rate of cash flows i.e. the rate of growth and duration of growth and

  2. Estimate of discount rate.

A small change in either of the value will have a significant impact on the estimated value.

Relative Valuation Approach
An advantage of the relative valuation approach is that they provide information about how the market is currently valuing the stock at several levels i.e. aggregate markets, different industries and individual stocks within industries. While the good news is that the relative valuation approach provides information about how the market is currently valuing the security, the bad news is that any one-valuation metric cannot be relied upon to arrive at a correct value. A firm needs to be evaluated using a minimum of 2-3 relative valuation metrics like price to earnings, price to book value and price to cash flow. Evaluating it using more than one metric is likely to give a much better picture of the overall valuation levels of a firm.

Relative valuation techniques are appropriate to consider under two circumstances.

  1. There are good sets of comparable entities i.e. comparable companies that are similar in terms of industry, size and risk.

  2. The aggregate market and the firm's industry are not at valuation extremes i.e. they are not seriously undervalued or overvalued.

It should be borne in mind that neither of the valuation technique is complete in itself. This is because of the fact that arriving at a valuation of a company requires estimates running well into the future and predicting the same with a high level of accuracy time and again is beyond humans. Hence, it is important to have an appropriate margin of safety incorporated into one's estimates so that even if there is an error, the fall in the stock price is not so huge so as to erode a significant portion of one's capital. In other words, higher the margin of safety, lower the chance of losing one's capital.

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