Equity Valuation Methods:

Equity valuation methods can be broadly classified into balance

sheet methods, discounted cash flow methods, and relative valuation
methods. Balance sheet methods comprise of book value, liquidation value,
and replacement value methods. Discounted cash flow methods include
dividend discount models and free cash flow models. Lastly, relative valuation
methods are a price to earnings ratios, price to book value ratios, price to
sales ratios etc.

A financial analyst primarily conducts two types of analysis for evaluation of

equity investment decisions viz. fundamental and technical analysis. All the
above methods are part of the fundamental analysis conducted by a financial
analyst. The technical analysis analyses the charts and graphs of the market
prices of a stock to understand the sentiments of the market. It believes in a
fact that history repeats itself. Many believe that it is used to decide the entry
and exit time from the market. On the other hand, fundamental equity
valuations methods attempt to find the fair market value of equity share. it
involves a study of the assets, earning potential, future prospects, future cash
flows, magnitude and probability of dividend payments etc.

CLASSIFICATION / TYPES OF EQUITY VALUATION

METHODS
Fundamental equity valuation methods are explained in brief under the
following categories.

Balance Sheet Methods / Techniques

Balance sheet methods are the methods which utilize the balance sheet
information to value a company. These techniques consider everything for
which accounting in the books of accounts is done.

Book Value Method

In this method, book value as per balance sheet is considered the value of
equity. Book value means the net worth of the company. Net worth is
calculated as follows:
Net Worth = Equity Share capital + Preference Share Capital + Reserves &
Surplus – Miscellaneous Expenditure (as per B/Sheet) – Accumulated Losses.

Liquidation Value Method:

Here, In liquidation cost method liquidation value is considered the value of
equity. Liquidation value is the value realized if the firm is liquidated today.

Liquidation Value = Net Realizable Value of All Assets – Amounts paid to All
Creditors including Preference Shareholders.

Replacement Cost Method:

Here, In replacement cost method the value of equity is the replacement
value. It means the cost that would be incurred to create a duplicate firm is
the value of the firm. It is assumed that the market value and replacement
value will coincide in the long run. The famous ratio by James Tobin is Tobin
q which tends to become 1. Tobin q is the ratio of market value to replacement
cost.
Equity Value = Replacement Cost of Assets – Liabilities.

Discounted Cash Flow Methods / Techniques:

Discounted cash flow methods are based on the fact that present value
all future dividends and the future price represent the market value of
equity.

Dividend Discount Model

This dividend discount model finds the present value of future dividends of a
company to derive the present market value of equity. There are various
models with different assumptions of a period of dividends and growth in
dividends.

Two-Stage Growth Model – Dividend Discount Model

The two-stage dividend discount model takes into account two stages of
growth. This method of equity valuation is not a model based on two cash
flows but is a two-stage model where the first stage may have a high growth
rate and the second stage is usually assumed to have a stable growth rate.

Two-Stage Dividend Discount Model:

The two-stage model can be used to value companies where the first stage
has an unstable initial growth rate. And, there is stable growth in the second
stage, which lasts forever. The first stage may have a positive, negative, or
volatile growth rate and will last for a finite period. Whereas, the second stage
is assumed to have a stable growth rate for the rest of the life of the company.
In this model, it is assumed that the dividend paid by a company also grows
in the same way, i.e., in two stages. Now, let’s look at the example to get a
better understanding of the concept of the two-stage dividend discount model.
Example Calculating Value of Stock/Share Using Two-Stage
Dividend Discount Model
Let’s take the example of a company (ABC Ltd.) that has paid a dividend of
$4 this year. Assuming a higher growth for the next 3 years at 15% and
stable growth of 4% thereafter. Let’s calculate the value using a two-stage
dividend discount model.

We need to do an adjustment here to arrive at the dividend amount that

needs to be discounted after adjusting for the different rates in the different
stages. Continuing with the above example and assuming a required rate of
return of 10%, we can calculate the value of the stock/firm as follows:

Current Dividend = $ 4.00

Dividend after 1st year will be = $ 4.60 ($ 4 x 1.15 – growing at 15 %)

After 2nd year will be = $ 5.29 ($ 4.60 x 1.15 – growing at 15%)

After 3rd year will be = $ 6.0835 ($ 5.29 x 1.15 – growing at 15%)

Since the growth in the first three years was 15%, the value of the dividend
declared after 3 years will be $6.0835, as calculated above.

The second stage has a growth rate of 4%, so the dividend value after the
4th year will be $6.0835 x 1.04 = $6.3268. Assuming this as the constant
dividend for the rest of the company’s life, we arrive at the present values,
as follow:

P0 = D / (i – g)

Where P0 = Value of the stock/equity

D = Per-Share dividend paid by the company at the end of each year

i = Discount rate, which is the required rate of return* that an investor

wants for the risk associated with the investment in equity against
investment in risk-free security.

g = Growth rate

*One of the most commonly used ways of calculating the required rate of
return is by using the Capital Asset Pricing (CAPM) model.

(Note: The formula for arriving at the present value remains similar to
earlier methods, such as single period dividend discount method, Gordon
growth model, etc.)

Now, using the formula for calculating the value of the firm, we can arrive at
the present value at the end of 3rd year for all future cash flows as follows:

Value = $6.3268 / (10% – 4%)

= $105.45
Table Showing Present Values

Tenor Cash Flow Discount Rate Present Value

1 4.6 10% 4.18

2 5.29 10% 4.37

3 6.0835 10% 4.57

3 105.45 10% 79.23

Total Present Value 92.35

Present value calculations in the above table are as follows:

$4.18 = $4.60 / (1 + 10%) ^1

$4.37 = $5.29 / (1 + 10%) ^2

$4.57 = $6.0835 / (1 + 10%) ^3

$79.23 = $105.45 / (1 + 10%) ^3

The sum of all the present values will be the value of the firm; in our
example, this comes to $92.35. Let’s look at how one should interpret
the value of the firm from an investor perspective.
Interpreting Firm Value Using Two-Stage Dividend
Discount Model:
The comparison of the market price to the value of the firm can help you
understand the market perception of the company. If the market price of the
company’s share is lower than the calculated value using this model, the stock
price is undervalued. This could mean that our estimates for the growth of the
company are higher than what the market perceives. It can also be interpreted
that one needs to revise the growth estimates to align the model value closer
to the market price of the stock; this is the implied growth rate. However, if
prices are marginally lower than the model price, one could assume that the
stock price is trading cheaper. And, it could be a good investment to make.

On contrary, if the market price is higher than the model output, it means that
the market expects the company to grow faster than our estimates.

Although the model has its benefits and applications; it inherits some
limitations as well. Let’s look at the limitations faced by the two-stage dividend
discount model.

Limitations of the Two-Stage Dividend Discount Model

• The model’s biggest limitation is the error in estimation that can
occur due to the incorrect estimation of the length of the first
stage. It is very difficult to estimate the length of the first stage,
which could lead to overvaluation or undervaluation of the stock
under consideration. A shorter first stage will cause the valuation
to be undervalued. While a longer first stage could lead to
overvaluation, in case of a high growth assumption in the first
stage.
• Secondly, assuming a direct jump from, for example, 12% in the
expansion stage to 4% stable growth in back-to-back years may
not be a scenario closer to reality. As, in the real-world scenario,
the growth rates will stabilize gradually over a period of time in
multiple stages, not just two.
• This model has its usage and applicability limited to companies
that have higher growth rates during the 1st phase, which is
known and has stable growth rates thereafter. Also, the growth
rates in the 1st phase should be closer to growth rates in stage
two. Essentially, if there is not much difference between the two
stages, the model will yield appropriate results.
There have been other models in use that tend to reduce the estimation error
of the two-staged dividend discount model. Such as the H model and three-
stage models, such that the valuation could be calibrated close to the market
reality. However, the two-stage model is still worthy of application to specific
cases and scenarios. As lesser stages require less estimation. And, business
models where high growth lasts only for a few years, after which there are no
reasons for high growth. In the case of an innovation/idea/product, a firm may
enjoy high growth rates until the patent expires or competitors jump in. For
such cases, a two-stage model is appropriate for use and application.

Free Cash Flow Model

This model is based on free cash flows of the company. Similar to above
model, it discounts the free future cash flows of the company to arrive at
an enterprise value. To find the value of equity, value of debt is deducted from
enterprise value.

Enterprise Value

What is Enterprise Value?

Enterprise Value (EV) is the measure of the total value of the company.
Instead of determining a firm’s value based on market capitalization only, it
gives the aggregate value of the firm as an enterprise.

In simple words, the EV of a company is a theoretical price at which it can be

bought. It is significantly different from market capitalization and considers
many other factors to arrive at the correct valuation of the business. Like for
example, if a firm has some debts and another organization takes it over. In
such a case, the firm taking over shall take over the debt of the firm too and
the same has to be paid by the taking over the firm. The EV considers all the
factors including the debt; this is not the case while determining the value as
per the market capitalization method. Thus while sizing up, the investors get
to know the actual valuation of the organization.

There is a formula to calculate the EV of the private company. Let us have a

look at the formula.
Enterprise Value Formula
The EV of the firm is calculated with the following formula:

Enterprise Value = Market Capitalization + Debt + Preferred Share Capital +

Minority Interest – Cash and cash equivalents

Let us take an example to see the calculation of Enterprise Value

Importance of Enterprise Value

Investors invest in a company when they know its true value. The highest
investment comes in those companies that generate higher cash flows along
with high enterprise value. EV is very critical for the value investors who
consider the value of a company beyond the outstanding equity. Debt and
cash have a huge impact on finding the correct valuation of a company. Both
the components do not form part of market capitalization to find the true
value of the company.

On the other hand, the EV acknowledges such aspects and helps in finding
the actual valuations of the enterprise. To sum up, Enterprise Value helps
the investors to know the accurate value of the company and determine
whether it is undervalued or not.

Conclusion

Enterprise Value plays a significant role for the investors to find the actual
value of the company. It helps in the comparison of companies having
different capital structures. During the takeover of the company, along with
the assets, the liabilities are also taken over. The liabilities include debts and
other components. It is obvious that now the debt will have to be paid by the
new organization that is taking over the firm. Thus, the actual value of the
company comprises of not only market capitalization but also the other
components. Going forward the concept of EV is going to become more
relevant and more organizations as well as investors will opt for this method
to know the true value of the company.

Earnings Multiple or Comparables or Relative Valuation

Methods / Techniques
Earnings multiple or Relative Valuation methods are also called comparable
methods because they use peers or competitors value to derive the value of
the equity. The importance here is of deciding which factor to be considered
for comparison and which companies should be considered peers. Following
are the well-known methods used for such comparison.

Price to Earnings Ratio

The price-earnings ratio, often called as P/E ratio is the ratio of
company’s stock price to the company’s earnings per share. It is a
market prospect ratio which is useful in valuing companies. In simple
words, P/E ratio is obtained by comparing the market price per share
with its relative dollar of earnings per share. The relationship between
the two essential parts of this ratio i.e. Market value of the stock and its
relative earnings shows what the market is willing to pay for a stock
based on its current earnings. Thus, it is also known as the price multiple
or the earnings multiple.

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decisions/equity-valuation-methods

P/E Ratio Valuation

As P/E ratio is the most common measure of how expensive a stock is,
it is essential to understand the basis & importance of its valuation.

The two most important components which form the basis of this
valuation is:
 1. Market value per share and
2. Earnings per share

Along with the above factors, this ratio can also significantly fluctuate
depending upon the economic and market conditions.

The following paragraphs will help you understand the importance of

such analysis through the P/E ratio formula and
calculation.

P/E Ratio Formula

The basic formula to calculate the price-earnings ratio is fairly standard
and is as under:

P/E Ratio = Market Price per Share / Earnings per Share

Market Price per Share: Market price per share is the price of each
share in the open market or how much it would cost to buy a share of
stock.
Earnings per Share (EPS): Earnings per share are total earnings of a
company for the year divided by the total number of shares
outstanding at the end of the year.

P/E Ratio Calculation

Let us calculate the price-earnings ratio on the basis of the above
formula.

Suppose, the market price per share of QPR Ltd. is Rs.100 and the
earnings per share are Rs.25, then the price-earning ratio shall be as
follows:

P/E Ratio = Rs.100 (Market Price) / Rs.25 (Earnings) = 4

This means that the Market price is 4 times the earnings of the company.

Benefits to Investors
Ratio analysis is very crucial for investment decisions, as it helps the investors
to know the real worth of their investment. The P/E ratio is useful in accessing
the relative attractiveness of a potential investment. It helps investors analyze
how much they should pay for a stock on the basis of its current earnings and
also shows if the market is overvaluing or undervaluing the company. It helps
in predicting future earnings per share through which the investors evaluate
what a stock’s fair market value should be.

P/E Ratio Analysis

Generally, the pe ratio indicates how many times earnings, the investors are
willing to pay for the share. The P/E ratio analysis shows the direct relationship
between the market price of the share of a company and its earnings. Hence,
if a company’s earnings per share rise; it leads to a rise in its market price,
while lower earnings per share indicate a fall in its market price. Thus, these
two factors mainly define the real performance and growth of a company.

Similarly, a company with a high pe ratio are often considered to be growth

stocks. This indicates higher earnings growth, positive performance in the
future and investors are usually willing to pay more for this company’s shares.
While on the other hand, a company with a lower pe ratio indicates poor
current and future earnings growth, the stock is undervalued, etc. Investing
in such company could prove to be a poor investment.

It is important to note that companies with high P/E ratios are more likely to
be considered as risky investments than those with lower ones. It is because
of the reason that a high P/E ratio signifies high expectations. This ratio is
useful only in comparing companies in the same industry. Any such
comparisons amongst companies of the different industry would provide an
incorrect result and thus, would mislead the investors.

Example
Let us understand this by an example. Suppose, there are two companies- A
Ltd. (belonging to the textile industry) and B Ltd. (belonging to the
pharmaceutical industry) with price-earnings ratios 4 and 5 respectively. Also,
there is one more company C Ltd. (belonging to the textile industry) with
price-earnings ratio 4.5.

Now, while analyzing the price-earnings ratios, one can compare A Ltd. with
C Ltd. since they belong to the same industry. As their valuation and growth
rates will more or less be alike. One should not or cannot compare either of
the two with B Ltd. as it would provide inappropriate results.

Conclusion

The P/E ratio is prominent for the investment valuation indicators. It is

because it indicates the expected price of a share based on its earnings.
And therefore, the investment community makes the extensive use of
this valuation metric.1–3

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Price to Book Value Ratios

Market to Book Ratio

What is Market-to-Book Ratio (M/B)?
The market-to-book ratio is simply a comparison of market value with the
book value of a given firm. In other words, it suggests how much investors
are paying against each dollar of book value in the balance sheet. Also known
as price-to-book value, this ratio tries to establish a relationship between the
book values expressed in the balance sheet and the actual market price of the
stock. Arithmetically, it is the ratio of market value to book value.

What is Market Value and Book Value?

Market value is the value derived by multiplying the stock price by the
number of outstanding shares. In simple words, we can also call it market
capitalization. On the other side, book value is a value derived from the
latest available balance sheet of a company. It is as good as the net asset
value of a company, which can be easily ascertained by taking all the assets
less depreciation and liabilities.
Calculate using Formula
The market-to-book value ratio can simply be calculated by using the
following formula:

Market-to-Book Ratio Formula

Market price per share / book value per share

OR

Market capitalization / book value

Either of the above formula can be used for calculating the ratio. The first
formula needs per share information, whereas the second one needs the
total values of the elements.

How to calculate the Book Values and Market Values for the
Formula?

For calculating book values for the purpose of deriving this ratio, an investor
can use the following formula:

Book Value = Total Assets – Total Liabilities – Preferred Stock – Intangible

Assets

or Book Value = Shareholder’s Equity (Broadly, Equity Share Capital +

Reserves and Surpluses)

Market Value = Market Price per share * No. of Equity Shares Outstanding.

Example
Assume there is a company X whose publicly traded stock price is $20 and it
has 100,000 outstanding equity shares. The book value of the company is
$1,500,000.
Market-to-book value ratio = 20* 1 00 000 / 1,500,000 =
2,000,000/1,500,000 = 1.33

Here, the market perceives a market value of 1.33 times the book value to
company X.

Analysis & Interpretation

It is important to understand the market-to-book value ratio when it is less
than 1 and greater than 1. A simple analysis can reflect undervaluation when
it is less than 1 and overvaluation when it is greater than 1.

Market-to-Book Ratio Less Than 1

Undervaluation – An Investment Opportunity

A normal investor would look at this as an investment opportunity. The basic

assumption behind this is most businesses have a higher market value
compared to their book values. For a majority, the assumption is also true,
and the reason is simple. The books of accounts record assets at their
purchase price. A business having purchased an asset, say a piece of land or
a building 20 years ago, must have much higher market realizable values, due
to the appreciation in real estate prices. In the balance sheet, the balance is
shown at the purchase price, so the book value is nowhere close to the real
fair market value of the business. Apart from these, there are intangible assets
that the business has created over the course of time. Most businesses have
not valued them in their books.

Overvaluation – Misrepresented Books

If we drill deep down, a ratio less than 1 means that the market does not even
perceive value equal to book value. In a less-than-ideal investment scenario,
an investor might smell some problem with the corporation. He may think
that the value of assets presented in the balance sheet may not be realizable
in the open market in the case of liquidation. Perhaps, in the case of
liquidation, selling off the assets will not realize a value equal to the book
value of the company. This may generally happen when some technologies
become obsolete. A machine whose technology is no longer useful in the
market will seldom find any buyers. Books may have any purchase value
assigned to them.

Market-to-Book Ratio Greater Than 1

Overvaluation – Book Values are Dynamic

In general, for an M/B greater than 1, you can interpret it as overvaluation,

but only when the book values are dynamic. By this, we mean that the book
value inculcates in it the true fair market values of all the assets and has
included the values for intangible assets, etc.

Undervaluation – Book Values just an Accounting Figure

We do not recommend using only this ratio to judge the overvaluation of the
business. Below are the reasons that undercut the reliability of book values
for any major analysis.

1. Book values normally ignore intangible assets’ fair value.

2. Book values represent historical values. The current fair value of
the assets may be much different from the balances in the
balance sheet, as explained above.
3. Future growth potential in earnings is also not considered in the
book values.

Given those reasons, book values can just be seen as an accounting figure.
Even a market-to-book value ratio just greater than 1 may not mean
overvaluation. It may even mean an undervaluation of the business. It may
possibly be worth 10 times the book value. For example, Apple had this ratio
ranging around 9 as of October 2018 and Amazon ranged around 20.

Before making any decision based on this ratio, we recommend comparing

this ratio with that of other industry peers. Also, we recommend using
other financial analysis ratios along with the B/M ratio.

Limitations
Like any other financial metrics, the market-to-book ratio also suffers from
some limitations. The primary issue is that it ignores the intangible assets of
a company, such as goodwill, brand equity, patents etc. In today’s business
world, it is well accepted that intangible assets have real value. There are also
ways and means of bringing them to the balance sheet, but every corporation
has not necessarily already done this. It also ignores the prospective earnings
growth of a business.
Therefore, this ratio is seldom meaningful where a corporation has majorly
intangible assets, such as software, know-how or knowledge-based companies
etc.

Uses
This ratio is primarily useful for existing and prospective investors, simply
because it is in their interest to know whether a company is under- or
overvalued. It is best suited for valuing a company in the fields of insurance,
finance, real estate investment trust etc.

Price-to-Book Ratio
Price-to-Book Ratio is just another name for the market-to-book ratio. There
is no difference between the ratios in terms of their formula, analysis or
interpretation.12

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book-ratio

Price to Sales Ratio