Valuation

 method for a stock

Great question! There are several valuation methods for stocks because each method offers a different perspective on a stock's value, and no single method is perfect for every situation. Here are the main categories:

1. Absolute Valuation Methods: These methods attempt to find the intrinsic or "true" value of a stock based on its own financial fundamentals. Examples include the Dividend Discount Model (DDM), Discounted Cash Flow (DCF) Model, Residual Income Model, and Asset-Based Model.

2. Relative Valuation Methods: These methods compare the stock to similar companies in the same industry. Common examples are the Price-to-Earnings (P/E) Ratio, Price-to-Book (P/B) Ratio, and Comparable Company Analysis.

Each method has its strengths and weaknesses, and often, analysts use multiple methods to get a more comprehensive view of a stock's value. This helps them make more informed investment decisions.

Does that help clarify things a bit?

y

Fantastic! If you ever want to dive deeper into any specific valuation method or have more questions, feel free to ask. I'm here to help. Have a great day! 😊

show example

Sure, I'd be happy to show an example. Let's take a look at the Discounted Cash Flow (DCF) Model to value a fictional company called "Tech Innovators Inc."

Step-by-Step Example of DCF Model

1. Forecast Free Cash Flows (FCF)

Estimate the company’s Free Cash Flows (FCF) for the next 5 years. Assume the FCF for Tech Innovators Inc. is as follows:

• Year 1: $1,000,000

• Year 2: $1,200,000

• Year 3: $1,500,000

• Year 4: $1,800,000

• Year 5: $2,000,000

2. Determine the Discount Rate

The discount rate reflects the risk of the company and can be determined using the Weighted Average Cost of Capital (WACC). Assume the WACC is 10%.

3. Calculate the Present Value of FCF

Discount each of the forecasted FCF to present value (PV) using the formula:

$$PV=\frac{FCF}{(1+WACC{)}^n}PV\; =\; \backslash frac\{FCF\}\{(1\; +\; WACC)^\{n\}\}$$

Here, $nn$ is the year number.

4. Calculate the Terminal Value (TV)

Estimate the company’s value beyond the forecast period using a perpetual growth rate. Assume a perpetual growth rate of 3%.

$$TV=\frac{FC{F}_{finalyear}\times (1+g)}{(WACC-g)}TV\; =\; \backslash frac\{FCF\_\{final\; year\}\; \backslash times\; (1\; +\; g)\}\{(WACC\; -\; g)\}$$

$$TV=\frac{2,000,000\times (1+0.03)}{(0.10-0.03)}TV\; =\; \backslash frac\{2,000,000\; \backslash times\; (1\; +\; 0.03)\}\{(0.10\; -\; 0.03)\}$$

$$TV=\frac{2,060,000}{0.07}TV\; =\; \backslash frac\{2,060,000\}\{0.07\}$$

$$TV=29,428,571TV\; =\; 29,428,571$$

Discount the terminal value to present value:

$$P{V}_{TV}=\frac{TV}{(1+WACC{)}^5}PV\_\{TV\}\; =\; \backslash frac\{TV\}\{(1\; +\; WACC)^\{5\}\}$$

$$P{V}_{TV}=\frac{29,428,571}{(1+0.10{)}^5}PV\_\{TV\}\; =\; \backslash frac\{29,428,571\}\{(1\; +\; 0.10)^\{5\}\}$$

$$P{V}_{TV}=18,255,294PV\_\{TV\}\; =\; 18,255,294$$

5. Calculate the Total Enterprise Value (EV)

Sum the present value of the FCF and the present value of the terminal value:

$$EV=P{V}_{FC{F}_{Year1}}+P{V}_{FC{F}_{Year2}}+P{V}_{FC{F}_{Year3}}+P{V}_{FC{F}_{Year4}}+P{V}_{FC{F}_{Year5}}+P{V}_{TV}EV\; =\; PV\_\{FCF\_\{Year1\}\}\; +\; PV\_\{FCF\_\{Year2\}\}\; +\; PV\_\{FCF\_\{Year3\}\}\; +\; PV\_\{FCF\_\{Year4\}\}\; +\; PV\_\{FCF\_\{Year5\}\}\; +\; PV\_\{TV\}$$

Here are the calculations for each year:

$$P{V}_{FC{F}_{Year1}}=\frac{1,000,000}{(1+0.10{)}^1}=909,091PV\_\{FCF\_\{Year1\}\}\; =\; \backslash frac\{1,000,000\}\{(1\; +\; 0.10)^\{1\}\}\; =\; 909,091$$

$$P{V}_{FC{F}_{Year2}}=\frac{1,200,000}{(1+0.10{)}^2}=991,736PV\_\{FCF\_\{Year2\}\}\; =\; \backslash frac\{1,200,000\}\{(1\; +\; 0.10)^\{2\}\}\; =\; 991,736$$

$$P{V}_{FC{F}_{Year3}}=\frac{1,500,000}{(1+0.10{)}^3}=1,127,541PV\_\{FCF\_\{Year3\}\}\; =\; \backslash frac\{1,500,000\}\{(1\; +\; 0.10)^\{3\}\}\; =\; 1,127,541$$

$$P{V}_{FC{F}_{Year4}}=\frac{1,800,000}{(1+0.10{)}^4}=1,227,901PV\_\{FCF\_\{Year4\}\}\; =\; \backslash frac\{1,800,000\}\{(1\; +\; 0.10)^\{4\}\}\; =\; 1,227,901$$

$$P{V}_{FC{F}_{Year5}}=\frac{2,000,000}{(1+0.10{)}^5}=1,242,665PV\_\{FCF\_\{Year5\}\}\; =\; \backslash frac\{2,000,000\}\{(1\; +\; 0.10)^\{5\}\}\; =\; 1,242,665$$

Adding them up:

$$EV=909,091+991,736+1,127,541+1,227,901+1,242,665+18,255,294EV\; =\; 909,091\; +\; 991,736\; +\; 1,127,541\; +\; 1,227,901\; +\; 1,242,665\; +\; 18,255,294$$

$$EV=23,754,228EV\; =\; 23,754,228$$

So, the estimated total enterprise value (EV) of Tech Innovators Inc. is approximately $23,754,228 using the DCF model. This is a simplified example, but it provides a good overview of the process.

I hope this helps! Let me know if you'd like to see examples of other valuation methods or have any other questions.