Investors and stock analysts use a variety of valuation models to arrive at the fair value of stocks. In fact they will generally use more than one model with a variety of assumptions and arrive at a range of possible fair values.
In this article we will briefly discuss three types of models, namely, discounted cash flow models, multiplier models, and asset-based models.
The discounted cash flow models, determine the value of a stock by calculating the present value of expected cash flows. These cash flows are of two types: expected cash flow to shareholders (dividend discount models), and the free cash flow to equity.
The multiplier models determine the value of a company by analyzing and comparing the company’s financial ratios. For example, a popular multiple is the price-earnings ratio. Other commonly used multiples are sales, book value, and cash flow per share.
There are other multiples, which are based on the enterprise value (EV), for example, EV/EBITDA, EV/EBIT, and EV/ Unlevered free cash flow (UFCF). These multiples are commonly used for valuing private firms.
Enterprise value, also called the firm value, is an economic measure that reflects the market value of the business. It includes claims to all security-holders, including equity, debt.
Asset-based models determine the fair value of a stock by calculating the value of the firm’s assets and subtracting the value of its liabilities and preferred stock. Since the firm’s assets and liabilities will be at book value, the analysts will adjust these values to their fair value.