5.4 Equity Valuation Methods

Investment advisers use various methods to determine whether stocks are fairly valued. Understanding these valuation techniques is essential for making investment recommendations and is heavily tested on the Series 65 exam.

Two Approaches to Valuation

Fundamental Analysis

Fundamental analysis examines a company's financial statements, economic conditions, and business prospects to determine its intrinsic value.

- Analyzes earnings, revenue, assets, and liabilities

- Considers industry conditions and competitive position

- Projects future cash flows and earnings

- Compares intrinsic value to market price

Technical Analysis

Technical analysis studies price patterns, trading volume, and market trends to predict future price movements.

- Charts and trend analysis

- Support and resistance levels

- Moving averages and momentum indicators

- Ignores fundamentals, focuses only on price and volume

Most questions on the Series 65 focus on fundamental analysis and specific valuation ratios.

Price-to-Earnings Ratio (P/E)

The P/E ratio is the most widely used valuation metric. It shows how much investors are willing to pay for each dollar of earnings.

Formula

P/E Ratio = Market Price per Share / Earnings per Share (EPS)

Types of P/E

Trailing P/E: Uses past 12 months actual earnings; Based on real numbers

Forward P/E: Uses estimated future earnings; More forward-looking

Interpreting P/E

High P/E (20+): Growth expected; investors pay premium

Low P/E (less than 15): Value stock; slow growth or problems

Negative P/E: Company has losses; P/E not meaningful

In Practice

A company with a P/E of 25 means investors pay $25 for every $1 of current earnings. If the industry average is 18, the stock is trading at a premium, either the market expects higher growth, or the stock may be overvalued.

Limitations

- Cannot use when earnings are negative

- Earnings can be manipulated through accounting choices

- Doesn't account for differences in growth rates

Price-to-Book Ratio (P/B)

The P/B ratio compares market value to accounting (book) value.

Formula

P/B Ratio = Market Price per Share / Book Value per Share

Where: Book Value = (Total Assets - Total Liabilities) / Shares Outstanding

Interpreting P/B

P/B less than 1: Stock trades below book value; may be undervalued

P/B = 1: Stock trades at book value

P/B greater than 1: Market values company above accounting value

Best Use Cases

- Financial institutions (banks, insurance companies)

- Asset-heavy companies (real estate, utilities)

- Distressed or cyclical companies

On the Exam

A P/B ratio below 1.0 doesn't automatically mean "buy", it may indicate the market expects write-downs of assets or future losses. Always consider why a stock trades below book value.

Price-to-Sales Ratio (P/S)

The P/S ratio compares stock price to revenue rather than earnings.

Formula

P/S Ratio = Market Price per Share / Revenue per Share

Or: Market Capitalization / Total Revenue

Advantages

- Can use when earnings are negative

- Revenue is harder to manipulate than earnings

- Useful for young or high-growth companies

Limitations

- Ignores profitability completely

- Industry-specific (compare within same industry)

- Low-margin businesses have low P/S by nature

PEG Ratio

The PEG ratio adjusts P/E for expected growth, making it useful for comparing companies with different growth rates.

Formula

PEG Ratio = P/E Ratio / Expected Earnings Growth Rate (%)

Interpreting PEG

PEG less than 1: Stock may be undervalued relative to growth

PEG = 1: Stock fairly valued relative to growth

PEG greater than 1: Stock may be overvalued relative to growth

Example

Company A: P/E 30; Growth Rate 30%; PEG 1.0

Company B: P/E 15; Growth Rate 10%; PEG 1.5

Despite a higher P/E, Company A has a lower PEG and may be the better value when considering growth.

Dividend Discount Model (DDM)

The Dividend Discount Model values a stock as the present value of all expected future dividends.

Basic DDM Formula

Stock Value = D1 / (r - g)

Where:

- D1 = Expected dividend next year

- r = Required rate of return (discount rate)

- g = Expected dividend growth rate (must be less than r)

This is also called the Gordon Growth Model or Constant Growth Model.

Example

A stock pays a $2 dividend expected to grow at 5% annually. The required return is 12%.

D1 = $2.00 x 1.05 = $2.10

Value = $2.10 / (0.12 - 0.05) = $2.10 / 0.07 = $30.00

If the stock trades at $25, it may be undervalued. If it trades at $40, it may be overvalued.

Assumptions and Limitations

Dividends grow at constant rate forever: Few companies maintain constant growth

Growth rate is less than required return: Model breaks if g is greater than or equal to r

Company pays dividends: Cannot use for non-dividend stocks

Dividends reflect value accurately: May not apply to growth companies

On the Exam

The DDM is most appropriate for:

- Mature, stable companies

- Companies with consistent dividend history

- Utility stocks, blue-chip stocks

- Companies with predictable earnings

The DDM is NOT appropriate for:

- High-growth companies reinvesting earnings

- Companies that don't pay dividends

- Cyclical companies with volatile earnings

Discounted Cash Flow (DCF) Analysis

DCF analysis values a company based on the present value of projected free cash flows.

Basic Approach

1. Project free cash flows for a forecast period (5-10 years)

2. Calculate terminal value at end of forecast period

3. Discount all cash flows to present value at required return

4. Sum = Intrinsic value of the company

Free Cash Flow vs. Dividends

DDM: Uses dividends only; Best for dividend-paying stocks

FCF Model: Uses operating cash flows; Best for all companies, control perspective

DCF is more flexible than DDM because it can value any company regardless of dividend policy.

Relative Valuation

Relative valuation compares a company to peers using multiples.

Common Comparable Multiples

P/E: Price / EPS; Profitable companies

EV/EBITDA: Enterprise Value / EBITDA; Capital-intensive businesses

P/B: Price / Book Value; Financial firms, asset-heavy

P/S: Price / Sales; High-growth, unprofitable

Process

1. Identify comparable companies (same industry, size, growth)

2. Calculate multiples for all comparables

3. Apply average or median multiple to target company

4. Estimate target's intrinsic value

Key Takeaways

- P/E ratio is most common; higher P/E suggests higher growth expectations

- P/B ratio compares to accounting value; useful for asset-heavy companies

- P/S ratio works when earnings are negative; compare within industry

- PEG ratio adjusts P/E for growth; PEG less than 1 may indicate undervaluation

- Dividend Discount Model values stock as PV of future dividends; requires stable, dividend-paying company

- DCF analysis is more flexible; works for any company with projectable cash flows

- Always compare valuations to industry peers and historical averages