Two Approaches to Valuing a Company, An Overview

Todd Voit |

1. Relative Valuation

Value is determined based on a company’s own history and industry comparable. Companies, and the market, typically trade within a range of valuation as a function of historical earnings growth, expected earnings growth, investment sentiment, corporate structure (use of debt, competition and business risk and more.

Two Approaches to Valuing a Company, An Overview 01/01/2018 Relative Valuation Value is determined based on a company’s own history and industry comparable. Companies, and the market, typically trade within a range of valuation as a function of historical earnings growth, expected earnings growth, investment sentiment, corporate structure (use of debt, competition and business risk and more. There are several metrics used as a measure of relative valuation with either considers the average high, average low and average 5 year Price-to-Earnings (PEs), Price-Sales (PS), Price to Book (PB) and Enterprise Value to Earnings before Interest Taxes, Depreciation and Amortization (EBITDA). While most firms use absolute numbers to determine whether the price of a stock is high relative to some underlying financial statement value (Earnings, Book Value, Sales, etc), Voit and Company uses a relative valuation approach in which a relative factor is determined of the relation between the current ratio or value (PE = 25) to its 5 year average low, high and its 5 year average to determine whether a stock price is truly over, under or fairly valued. For example, while a PE of 25 might seem quite high, it may be deservedly so due to high earnings growth prospects, however, it may not be high relative to the company or industry’s typical valuation range (20 to 50, average 35). In this case, the stock is trading at 1.2 times its 5 year average low and .50 of its 5 year average high and .60 of its 5 year average indicating that the stock is not overvalued relative to its historical or industry norms. This same process is applied to EV/EBITDA, PB, PS and other valuation criteria.

2. Discounted Cashflow

A discounted cashflow valuation model determines a firm’s intrinsic value per share using dividends, cashflow or free cashflow and using required return, an intrinsic values per share can be determined.  This is then compared to the current price of the stock to determine is the share price observed in the market is overvalued (Actual price > intrinsic value per share) or undervalued (actual price < intrinsic value per share).  An investor can combine both approaches to come up with a range of intrinsic values the firm should currently be trading in and target values the firm shares should be trading at over the next three years.

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