Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.

Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Equity valuation - An insight - Views on News from Equitymaster
  • E-MAIL
  • A  A  A
  • Mar 29, 2007

    Equity valuation - An insight

    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 Flow Discount 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.



    Equitymaster requests your view! Post a comment on "Equity valuation - An insight". Click here!


    More Views on News

    How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

    Jun 10, 2017

    Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

    Why Hasn't Warren Buffett Rung the Bell Yet? (The 5 Minute Wrapup)

    Aug 22, 2017

    It's surprising Warren Buffett hasn't warned investors about the expensive stock market? Let us know why.

    Think Twice Before You Keep Money In A Savings Bank Account (Outside View)

    Aug 22, 2017

    Post demonetisation, a cut in bank savings deposits rates was in the offing.

    A Darkness Is Spreading Across the US (Vivek Kaul's Diary)

    Aug 22, 2017

    Today, we are attacked by one preposterous thing after another, each of them even more absurd than the last.

    Dear PM Modi, India is Already Land of Self-Employed, and It Ain't Working (Vivek Kaul's Diary)

    Aug 21, 2017

    Most Indians who cannot find jobs, look at becoming self-employed.

    More Views on News

    Most Popular

    A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

    Aug 10, 2017

    Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

    The Most Important Innovation in Finance Since Gold Coins(Vivek Kaul's Diary)

    Aug 10, 2017

    Bill connects the dots...between money and growth, real money and real resources, gold and cryptocurrencies...and between gold, cryptocurrencies, and time.

    Signs of Life in the India VIX(Daily Profit Hunter)

    Aug 12, 2017

    The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

    Bitcoin Continues Stellar Rise(Chart Of The Day)

    Aug 10, 2017

    Bitcoin hits an all-time high, is there more upside left?

    5 Steps To Become Financially Independent(Outside View)

    Aug 16, 2017

    Ensure your financial Independence, and pledge to start the journey towards financial freedom today!

    Copyright © Equitymaster Agora Research Private Limited. All rights reserved.
    Any act of copying, reproducing or distributing this newsletter whether wholly or in part, for any purpose without the permission of Equitymaster is strictly prohibited and shall be deemed to be copyright infringement.

    LEGAL DISCLAIMER: Equitymaster Agora Research Private Limited (hereinafter referred as 'Equitymaster') is an independent equity research Company. Equitymaster is not an Investment Adviser. Information herein should be regarded as a resource only and should be used at one's own risk. This is not an offer to sell or solicitation to buy any securities and Equitymaster will not be liable for any losses incurred or investment(s) made or decisions taken/or not taken based on the information provided herein. Information contained herein does not constitute investment advice or a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual subscribers. Before acting on any recommendation, subscribers should consider whether it is suitable for their particular circumstances and, if necessary, seek an independent professional advice. This is not directed for access or use by anyone in a country, especially, USA or Canada, where such use or access is unlawful or which may subject Equitymaster or its affiliates to any registration or licensing requirement. All content and information is provided on an 'As Is' basis by Equitymaster. Information herein is believed to be reliable but Equitymaster does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. Equitymaster may hold shares in the company/ies discussed herein. As a condition to accessing Equitymaster content and website, you agree to our Terms and Conditions of Use, available here. The performance data quoted represents past performance and does not guarantee future results.

    SEBI (Research Analysts) Regulations 2014, Registration No. INH000000537.

    Equitymaster Agora Research Private Limited. 103, Regent Chambers, Above Status Restaurant, Nariman Point, Mumbai - 400 021. India.
    Telephone: +91-22-61434055. Fax: +91-22-22028550. Email: info@equitymaster.com. Website: www.equitymaster.com. CIN:U74999MH2007PTC175407

    Become A Smarter Investor In
    Just 5 Minutes

    Multibagger Stocks Guide 2017
    Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
    We will never sell or rent your email id.
    Please read our Terms


    Aug 22, 2017 (Close)