Analysts and traders use stock valuation methods to determine the intrinsic value of a share.
Prof. Eugen Fama’s efficient market theory helps in defining the intrinsic value of the share. The intrinsic value of a share is the value an investor would assign if they knew everything about the share.
Traders compare the intrinsic value with the market price to ascertain whether the share is adequately priced. In this way, traders can decide whether to buy, sell, or hold the shares based on their current price.
If the share’s intrinsic value is higher than the market price, the stock is undervalued, and the right course of action would be to buy the share.
If the share’s intrinsic value is lower than the market price, the stock is overvalued, and traders should sell the share.
To summarize:
Intrinsic value < Market value = Overvalued (short/sell signal)
Intrinsic value > Market value = Undervalued (long/buy signal)
It is imperative to note that to take a position in a stock identified as mispriced in the market, a trader should believe that the market would eventually move towards the estimated intrinsic value of a share.
For estimating the equity value, traders use a variety of stock valuation methods. Usually, they use more than one method to develop a range of possible values.
Let us discuss how to value a stock by looking at valuation methods for shares in detail:
1. Discounted cash flow model
This method determines the value of a share to estimate the present value of future cash flows expected to be received by the organization.
Cashflows can either be dividends expected to be distributed to shareholders (dividend discount models) or the net cash flows available after meeting working capital requirements and capital expenditures (free cash flows to equity models).
Dividend Discount Model:
The most general formula for the model is as follows:
∞
Vo = Σ Dt (1+Ke) t
t=1
Vo = value of stock
D= Dividend at time t
Ke= Cost of equity
Dividend discount models can be used as single-stage or multistage, depending on the company’s growth rate whose stock is being valued.
An example for this stock valuation model is as follows:
A company paid a dividend equal to ₹ 1/share last year, which is expected to grow by 5% every year forever. The cost of equity is equal to 10%. Find the intrinsic value of a share.
In the above example:
D0= ₹ 1
D1= ₹ 1.05
G = 5%
Ke= 10%
Using Gordon’s growth model,
Vo= 1.05
(0.10 – 0.05)
V0= ₹ 21
Free Cash Flow to Equity (FCFE):
FCFE is the cash available to the equity holders after meeting all obligations of the firm.
It can be calculated as follows:
FCFE = Net income + Depreciation – Changes in working capital – Capital expenditure – Principal debt repayments + New debt issued
Value of a share using FCFE
∞
(Vo) = Σ FCFEt (1+Ke)t
t=1
2. Multiplier Model
In multiplier models, the financial ratios of a company are analyzed and compared to determine the value of the company.
Multiplier Models cover multiples based on price and multiples based on comparables.
Price Multiples used for valuation include:
Price Earnings Ratio:
The P/E ratio is the ratio of stock price to earnings per share and is the most used stock valuation method.
Price-Sales Ratio:
This is the ratio of price per share to sales per share.
Price-Book Value Ratio:
The ratio divides share price to book value per share.
Multiples based on comparables include:
1. EV/EBITDA:
Ratio of enterprise value to earnings before interest, depreciation and tax.
Where Enterprise Value = Market value of equity + Market value of debt- Cash and cash equivalents
2. EV/EBIT:
Ratio of enterprise value to earnings before interest and tax.
For example:
The following information pertains to Company X, which is a peer of Company A.
Stock Price: ₹ 50
Shares Outstanding: 100,000
Market Value of long-term debt: ₹ 700,000
Book Value of long-term debt: ₹ 10,00,000
Book Value of Total Debt: ₹ 18,00,000
Cash & Cash equivalents: ₹ 250,000
EBITDA: ₹ 500,000
Calculate the EV/EBITDA Multiple. Further, calculate EV of Company A if EBITDA is ₹ 400,000.
Enterprise Value = Market Value of Equity + Market Value of Debt – Cash & Cash Equivalents
Market Value of Equity = 50*100,000= ₹ 50,00,000.
Market Value of Total Debt = ₹ 700,000+ ₹ 800,000 = ₹ 15,00,000
Thus, EV = 50,00,000+15,00,000 – 250,000 = ₹ 62,50,000
EV/EBITDA = ₹ 62,50,000/ ₹ 500,000 = 12.50
Enterprise Value of Company A = 12.50 x 400,000 = ₹ 50,00,000.
3. Asset-Based Valuation Model
This stock valuation method is based on the assumption that the market value of equity is equal to the fair value of assets minus the fair value of liabilities.
Asset-based valuation models are most reliable when the firm has primarily tangible short-term assets or assets with readily available market value. It is suited in situations where a firm is on the verge of being liquidated or will cease to operate.
For example:
The following details pertain to HDT Limited. The firm has 1000 shares. Calculate the value per share.
Cash ₹ 10,000
Accounts Receivable ₹ 50,000
Inventories ₹ 70,000
Fixed Assets ₹ 250,000
Accounts Payable ₹ 40,000
Long-term Debt ₹ 200,000
Shareholder’s Equity ₹ 140,000
The market value of fixed assets is 115% of book value, and the market value of other liabilities and assets are the same as their book values.
Fair Value of assets = ₹ 10,000+ ₹ 50,000+ ₹ 70,000+ ₹ 287,500 = ₹417,500
Fair Value of liabilities = ₹ 40,000+ ₹ 200,000 = ₹ 240,000
Thus, Net Assets = ₹ 177,500
Value per share = ₹ 177,500/1000 shares = ₹ 177.50
To conclude, there is no ‘one-size-fits-all model of valuation, but by knowing the company’s characteristics, you can choose the one that is right for you.
