Absolute Equity Valuation, Part I: An Overview

Present Value of Cash FlowsIn his seminal 1938 work, “The Theory of Investment Value,” John Burr Williams expounded on his theory that a common stock’s intrinsic value equals the present value of all its future dividends. Since then, considerable advances have been made in the field of security analysis and valuation. But the basic principals have remained the same.

This article is the first in a series comprising a basic overview of absolute security valuation as it applies to the common equity of domestic public companies. Our topics will include popular cash flow definitions, their formulas, underlying assumptions, applications, and multistage model equations. A detailed discussion of determining discount rates and growth rates is beyond the scope of this particular series.

Valuation Models:

Absolute valuation models supply a point estimate of intrinsic value in absolute terms for a company’s common stock. What is the most I should pay for this stock? The present value or discounted cash flow model forms the basis of valuation. Required inputs include the time horizon, a specific measure of cash flow, the appropriate discount rate, and the terminal value.

Relative valuation models, also known as market-based models compare a company’s stock price to a benchmark in relative rather than absolute terms. Is the stock overvalued, undervalued, or fairly valued compared with this benchmark? Relative valuation is the topic of another series that will follow (hopefully soon).

Multistage Valuation Models:

A valuation model can consist of one or more stages, each representing a specific growth period in a company’s life cycle. A single-stage model may suffice for valuing a mature company forecasted to have a constant sustainable growth rate. A company in its growth stage might be valued using a three-stage model: a high growth, a mature growth, and a transitional stage in between.

More complex growth patterns can be modeled using basic valuation formulas as building blocks in spreadsheet applications. A range of intrinsic values can be calculated by varying the inputs to a valuation model.

Measures of Cash Flow:

Common stockholders have an ownership claim on all future cash flows. Dividends are a measure of actual distributions at the shareholder level. Free cash flow to equity and residual income are two examples of measures of cash flow at the company level that could be distributed, but are not actually paid to shareholders.

Dividends are less volatile, more stable over time, and less sensitive to short term fluctuations than earnings. Dividends represent a non-controlling ownership perspective at the stockholder level, and are a form of direct access to company value. As a measure of cash flow, dividends are more appropriate for a mature company whose board has established a consistent dividend policy.

Free cash flow to equity (FCFE) recognizes a going concern’s need to replace capital. FCFE represents a controlling ownership perspective at the company level. FCFE is more suited for a company that does not pay a dividend, or pays an amount significantly different than is available according to FCFE.

Residual income (RI) explicitly recognizes the cost of equity capital. RI may be suitable when a company does not pay a dividend, or has negative or unpredictable FCFE. Calculating RI can sometimes require skillful adjustments to financial data.

Conclusion:

When using any valuation model, care must be taken in understanding its underlying assumptions, and the applications for which it is best suited. A stock valuation skill set should include a basic understanding of various cash flow measures and their application to a company’s the growth stages.

The next article will introduce the dividend discount model, a present value model using dividends as the measure of cash flow.

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2 Comments

  • By Jim Kopas, July 19, 2010 @ 3:20 pm

    Great Post Sargon! It is critical for an analyst to have a strong understanding of all the strengths/weaknesses of these different valuation models in order to correctly assess a company’s intrinsic valuation. I am confident that going forward you will cover all these important aspects in greater detail. Keep up the good work!

Other Links to this Post

  1. Absolute Equity Valuation, Part II: Dividend Discount Model | Sargon Y. Zia, merging fundamental analysis with technical analysis — August 1, 2010 @ 9:15 am

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