So you are finally convinced that stock investing is important, and will like to start learning and investing in it. One of the first thing you will need to know is how to spot a good deal when buying stocks, or as what the financial gurus love to say, an undervalued stock.
Whether a stock is a good deal or not could very much depend on your valuation method. And there are various methods to consider. You may not need to know every single valuation method, but you will do good to at least know the common ones and when each of these methods are being utilized.
No single method can be applied to all businesses because every stock is different. Each industry sector may have its own unique properties that may require varying valuation approach.
Today, we will try our best to explain the cases of when to use two common types of valuation methods.
Two Classifications of Valuation Models
Valuation methods typically fall into two main categories: Absolute Valuation Models and Relative Valuation Models.
Absolute valuation models attempt to find the intrinsic or “true” value of an investment based only on fundamentals (fundamentals refer to items which can be found in an annual report) such as dividends, cash flow and net assets. Valuation models that fall into this category include the dividend discount model, discounted cash flow model, residual income models and asset-based models.
Relative valuation models operate by comparing the company in question to other similar companies. These methods generally involve calculating multiples or ratios, such as the price-to-earnings multiple, and comparing them to the multiples of other similar firms from the same industry.
We will look at two types of absolute valuation models today.
Dividend Discount Model (DDM)
The dividend discount model (DDM) is one of the most basic absolute valuation models around and also frequently taught in finance classes. As the name suggests, it calculates the intrinsic value of a firm based on its dividends payout. The rational for using dividends is because it represents the income a shareholder receives for investing in the company.
Complicating formula isn’t it?
This model has quite a fair bit of limitations. Firstly, the method will only work for companies that pay dividends. If a company does not pay dividends even when it makes profit, there will be no basis to form a valuation.
Secondly, the dividends need to be stable and predictable. Otherwise, the valuation would be too volatile if an investor were to use this model.
For instance, a cyclical company that pays a dividend only when it is earning big bucks (e.g. once in 5 years) will not fit the bill. Thus, this valuation method is best suited for companies that pay stable and predictable dividends are typically mature blue-chip companies in mature and well-developed industries.
Discounted Cash Flow Model (DCF)
What If the company you are looking into has strong cash flow but choses not to pay dividends, preferring instead to use it for its own expansion? In this case, you can look at the Discounted Cash Flow (DCF) model. This model can be used with a wide variety of firms that don’t pay dividends, and even for companies that do pay dividends.
The DCF model is quite similar to the DDM where you replace the dividends with free cash flow. How it works is that free cash flows are generally forecasted for five to ten years, and then a terminal value is calculated to account for all the cash flows beyond the forecast period.
To use this model, the company needs to have predictable positive free cash flows. Free cash flow is coined as operating cash flow minus capital expenditure. When you look at the table below, you will realize that the company is in fact, investing much more than what it generates. As a result, the free cash flow becomes negative and it would become impossible for this model to be used. This typically holds true for companies in the airline industry, where it has to pay hefty investment would need to be made for airplanes bought.
|Operating Cash Flow||438||789||1462||890||2565||510|
|Free Cash Flow||-347||-206||330||-366||330||-1036|
Therefore, companies which can utilize this model most effectively are mature firms that are past the growth stages or do not require huge amount of capital expenditures.
In our next article, we shall look at the category of relative valuation methods – where the more familiar P/E and P/B ratios reside in. So stay tuned!
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