Fundamental analysis is often employed in valuation, although several other methods may be employed such as the capital asset pricing model (CAPM) or the dividend discount model (DDM).
Key Takeaways
- Valuation is a quantitative process of determining the fair value of an asset or a firm.
- In general, a company can be valued on its own on an absolute basis, or else on a relative basis compared to other similar companies or assets.
- There are several methods and techniques for arriving at a valuation—each of which may produce a different value.
- Valuations can be quickly impacted by corporate earnings.
What Does Valuation Tell You?
A valuation can be useful when trying to determine the fair value of a security, which is determined by what a buyer is willing to pay a seller, assuming both parties enter the transaction willingly. When a security trades on an exchange, buyers and sellers determine the market value of a stock or bond.
The concept of intrinsic value, however, refers to the perceived value of a security based on future earnings or some other company attribute unrelated to the market price of a security. That's where valuation comes into play. Analysts do a valuation to determine whether a company or asset is overvalued or undervalued by the market.
The Two Main Categories of Valuation Methods
Absolute valuation models attempt to find the intrinsic or "true" value of an investment based only on fundamentals. Looking at fundamentals simply means you would only focus on such things as dividends, cash flow, and the growth rate for a single company, and not worry about any other companies. Valuation models that fall into this category include the dividend discount model, discounted cash flow model, residual income model, and asset-based model.
Relative valuation models, in contrast, operate by comparing the company in question to other similar companies. These methods involve calculating multiples and ratios, such as the price-to-earnings multiple, and comparing them to the multiples of similar companies.
For example, if the P/E of a company is lower than the P/E multiple of a comparable company, the original company might be considered undervalued. Typically, the relative valuation model is a lot easier and quicker to calculate than the absolute valuation model, which is why many investors and analysts begin their analysis with this model.
How Earnings Affect Valuation
The earnings per share (EPS) formula is stated as earnings available to common shareholders divided by the number of common stock shares outstanding. EPS is an indicator of company profit because the more earnings a company can generate per share, the more valuable each share is to investors.
Analysts also use the price-to-earnings (P/E) ratio for stock valuation, which is calculated as market price per share divided by EPS. The P/E ratio calculates how expensive a stock price is relative to the earnings produced per share.
For example, if the P/E ratio of a stock is 20 times earnings, an analyst compares that P/E ratio with other companies in the same industry and with the ratio for the broader market. In equity analysis, using ratios like the P/E to value a company is called a multiples-based, or multiples approach, valuation. Other multiples, such as EV/EBITDA, are compared with similar companies and historical multiples to calculate intrinsic value.
