Stock valuation is important part on investment decision. The stock valuation is used to get the intrinsic value or fair value of stock. The information about intrinsic value will be used to decide whether we want to buy or to sell the stock.
There are two ways to calculate the value of stock. The first is using discounted cash flow (DCF) model and comparable multiple approach. The DCF model is based on present value calculation. The value of stock is the present value of expected future cash flows. In investor point of view the cash flows are dividends received from the company and the capital gains/loss.
The comparable multiple approach use the financial ratios to calculate the value/price of stock. The examples of this approach are EBIT Multiple, EBITDA Multiple, Market to Book Value Multiple, and P/E Multiple. When we want to use this approach we must have information about financial ratios from industry or benchmark firms. This approach has several pros and cons.
Pros of multiple approaches:
- Convenient
- Reflects what the market is willing to pay for a comparable firm
- Particularly helpful when firm is not in steady state
Cons of multiple approaches:
- Ignores need to make explicit assumptions regarding long-term profitability and growth
- Subject to market misevaluation
- Subject to accounting distortions
- A relative (rather than absolute) valuation measure
- Difficulty in identifying comparable firms
- Meaningless with negative values
- Denominator may be more cyclical than numerator
FINANCE 560 