Fundamentals of Equity Valuation 365

Market value

Current market price of a company’s stock; reflects investor expectations about future performance, set by supply and demand

Intrinsic value

Fair value of a stock derived from fundamentals; what investors would pay with complete knowledge of company characteristics

When to compare market vs intrinsic value

Use percentage difference between market price and intrinsic value to identify mispricing; consider trading costs, model confidence, and market efficiency

Factors affecting market efficiency

Number of participants, availability of information, trading limits, transaction costs; more participants and data improve efficiency

Present value models

Estimate stock’s intrinsic price as the PV of expected future benefits; best for companies with predictable cash flows or dividends

Dividend Discount Model (DDM)

Used when a company pays dividends consistently; calculates intrinsic value as PV of expected future dividends

Gordon Growth Model

DDM assuming constant dividend growth; ideal for mature, stable companies like utilities

Multistage DDM

Used when a company has high initial growth that slows to a stable rate; calculate PV for each stage separately

Free Cash Flow to Equity (FCFE)

Model used for companies that don’t pay dividends regularly; measures cash available to equity shareholders after all expenses, reinvestment, and debt

When to use FCFE

High-growth or young companies, companies with irregular dividends, or firms reinvesting heavily; not reliant on dividends

FCFE Formula

FCFE = Net Income + Depreciation - CAPEX - ΔNWC + Net Borrowing

Cost of Equity

Required return for equity investors; used to discount future dividends or FCFE

CAPM Formula

Cost of Equity = Risk-free rate + Beta * Market Risk Premium

Bond Yield + Risk Premium Approach

Alternative method to estimate cost of equity; adds risk premium to bond yields

Preferred Stock

Fixed dividend, hybrid of equity and debt; use valuation model P0 = D / r for noncallable preferred stocks

Multiplier models

Evaluate intrinsic value using ratios like P/E, P/B, P/S, P/CF; best for comparing similar companies or industry benchmarking

Price Multiples

Compare stock price to per-share financial metric; can be trailing (past 12 months) or forward (next 12 months)

Advantages of price multiples

Quick to calculate, allow cross-sectional and time-series analysis, easy comparables

Disadvantages of price multiples

Sensitive to accounting differences, backward-looking, not always meaningful when metric is negative

Enterprise Value Multiples

Compare EV to EBIT, EBITDA, or revenue; useful for companies with different capital structures

When to use EV multiples

For leveraged companies or when comparing across firms with varying debt levels

Asset-based models

Estimate market value of a company’s assets; adjust book values to fair value; provides a valuation floor

When to use asset-based models

When liquidation is possible, for distressed companies, or as a conservative floor valuation

Replacement Cost Method

Asset-based valuation estimating cost to replace existing assets; limited use for intangible-heavy businesses

Dividend types

Cash (regular, special, liquidating) or stock; affects shareholder wealth differently but total equity unchanged

Share repurchase

Reduces shares outstanding, signals undervaluation, often preferred over dividends for tax efficiency

Stock splits

Increase number of shares, lower price per share, total shareholder wealth unchanged

Reverse stock splits

Reduce number of shares, raise price per share, total shareholder wealth unchanged

Dividend Payment Chronology

Declaration date → Ex-dividend date → Holder-of-record date → Payment date; important for timing and eligibility

Sensitivity Analysis

Used to test valuation outcomes against changes in assumptions such as growth rates, required return, or payout ratios

Law of One Price

Identical assets should have identical prices; used in relative valuation to justify comparables

Relative Valuation

Supports intrinsic models; good when inputs to DCF/DDM are uncertain or highly sensitive

When to use DDM vs FCFE

DDM: mature, dividend-paying firms; FCFE: high-growth or irregular dividend firms

When to use multiples

Quick comparisons within an industry; check P/E, P/B, P/S, P/CF; adjust for company-specific factors like leverage or business model

When to use asset-based

Minimum/floor valuation; distressed, liquidation, or tangible-asset-heavy companies