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Equity Valuation Models to Evaluate Stock Values

Easily the most difficult part of investing in stocks is figuring out what they’re worth and projecting how their prices will change. There are a number of different influences on the value and price of a stock. You can measure the stock itself using any of a number of equity valuation models.

Far too many different valuation models are in use to be able to talk about each one, many of which are becoming very involved due to the increased use of computers and financial engineering. There are really only three primary categories of equity valuation models, though:

  • Absolute models, sometimes called intrinsic models, look for the value of the company itself; seeking to find a measure that can capture the exact value of each company. These include such models as the following:

    • The dividend discount model attempts to utilize the present discounted value of future dividends to value the price of a stock.

    • The liquidation value is the total of the revenues that could be achieved from selling all corporate assets after paying back liabilities; used as a price floor for total market capitalization.

    • The free cash flow method estimates cash flows to the firm and to equity, to estimate both fair price and growth rates.

  • Relative models, sometimes called extrinsic models, intend to understand how the price or value of a company can be assessed by looking at variables that are influenced, at least in part, by things outside the corporation’s control, such as stock price, other corporations in the sector, and the performance of a corporation relative to economic and market performance ratios. Such ratios often include measures that involve comparisons to the sector, to the economy, or to stock price. Common values included in these models are earnings per share, the price-to-earnings ratio, and market responsiveness.

  • Hybrid models tend to be more complex but only in the sense that they attempt to utilize methods employed by both absolute and relative models. Often they attempt to find differentials in the intrinsic and extrinsic values.

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