Outline the main families of equity valuation model and what each gains or gives up
The idea
Equity valuation models fall into three broad categories. Present value models, such as dividend discount and free cash flow models, estimate intrinsic value from forecast cash flows discounted at a required return. They rest on fundamentals but are highly sensitive to growth and discount rate assumptions. Multiplier models apply a ratio such as P/E or EV/EBITDA from peers or history; they are quick and market-based, but only say whether a share is cheap relative to something that may itself be mispriced. Asset-based models value assets less liabilities at fair value; they suit holding companies, resource firms and liquidations, but miss intangibles such as brands and staff. Analysts often use several and investigate where the answers diverge.
A practice question
Valuing a company by applying its peer group's median EV/EBITDA to its own EBITDA is an example of a:
- multiplier model — correct
- present value modelWhy not: A present value model discounts forecast cash flows. Applying a peer ratio discounts nothing.
- asset-based modelWhy not: An asset-based model values assets less liabilities at fair value, not earnings at a peer multiple.
Multiplier (market multiple) models value a company by applying a ratio observed for comparable firms, or for the company's own history, to one of its financial measures.
A harder one
The main disadvantage of discounted cash flow valuation models is that they are:
- unable to reflect the time value of moneyWhy not: Discounting is precisely how these models account for the time value of money.
- reliant on how the market prices peer companiesWhy not: That is the weakness of multiplier models. DCF models are built from the company's own forecasts.
- very sensitive to growth and discount rate inputs — correct
Present value models rest on fundamentals, but small changes in long-run growth or the required return can move the value a great deal, and those are the inputs hardest to estimate.
The hardest tier
A share trades at 50. An analyst's DCF value is 42, and applying the peer group's P/E gives 55. The most reasonable interpretation is that the share:
- is undervalued, as both methods show a higher valueWhy not: Only the multiple gives a value above 50. The DCF value of 42 is below the market price.
- must be mispriced by the analyst's DCF, not peersWhy not: Neither method is automatically right. The gap may equally reflect a sector the market prices too highly.
- looks cheap against peers but dear on fundamentals — correct
The two methods answer different questions: the DCF compares the price with intrinsic value, the multiple with peers. A result like this suggests the whole peer group may be richly priced, which the analyst should investigate.
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