Other valuation methods
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As you’ve already seen in the previous chapter, the Discounted Cash Flow method is quite popular and widely used. However, depending on the circumstances surrounding a company, many investors also utilise other valuation methods. That’s exactly what we will be looking at in this chapter. We’ll start off with another absolute valuation method that’s almost as popular as the Discounted Cash Flow method - the Dividend Discount Model (DDM).
Dividend Discount Model (DDM)
The Dividend Discount Model (DDM) is a valuation technique that works on the assumption that the present value of all the future dividends of the company represent the intrinsic value of its share price.
Since a company distributes dividends to its shareholders from its free cash flows, this model assumes the dividends to be an accurate representation of a company’s free cash flows. This is primarily the reason why the DDM utilises dividends rather than free cash flows.
With the following formula, you can easily calculate the intrinsic value of a company’s stock using the DDM method.
V0 = D1 ÷ (R - G) |
Here,
V0 = The intrinsic value of the stock
D1 = The expected dividend per share for the forthcoming period
R = The estimated cost of equity
G = The expected dividend growth rate
This model is also known as the Gordon Growth Model (GGM), named after the American economist Myron J. Gordon. It works on the assumption that the dividends of a company’s stock would likely grow at a constant rate for the years to come. The GGM model requires you make several assumptions with respect to the expected dividend per share for the forthcoming period and the constant dividend growth rate.
What kind of companies is this method suitable for?
Since this valuation model requires you to assume that a company’s dividends would grow at a constant rate, the Dividend Discount Model only works for companies that consistently distribute dividends. Therefore, this valuation method is more suitable for large-cap and mature companies.
Market value valuation method
The market value valuation method is one of the simplest ways to measure a stock’s value. It is a relative valuation model that involves comparing the value of similar companies that have recently sold off to determine the value of a company. For instance, say there are 2 companies - company A and company B - that are both operating in the same industry and are quite similar. Company B decides to sell its entire business to a third entity for a specified sum of money. The market value valuation method involves determining the value of company A by comparing it with the value at which company B sold off its business.
What kind of companies is this method suitable for?
Although this method may not be as accurate as the other valuation methods, it still gives you a fair idea of what the value a company might be. That said, this method works only on companies whose competitors are very similar in nature with respect to the business model and the financial structure.
Also, another prerequisite for this method to work is the sale of the competitor’s company. The market value method can be quite challenging since it may be hard to find two companies in the same industry and sector that are very similar to each other.
Asset-based valuation method
The asset-based valuation method involves determining the value of a company by computing its net asset value, which is the total value of assets minus the total value of liabilities. There are two different ways in which you can compute a company’s value using this method - the going concern approach and the liquidation value approach. Let’s take a brief look at both of these.
1. The going concern approach
This approach assumes that the company whose value that you’re trying to determine will continue to operate in the near future without the threat of liquidation. To determine the value of a company using this approach, you need to subtract the total liabilities of the company from its total assets. Then, divide the resulting figure by the number of outstanding shares to get the value of a single share of the company.
2. The liquidation value approach
The liquidation value approach works on the assumption that the company is in the process of closing down and liquidating its assets. Here, the net cash that the company is left with after selling off all of its assets and using the proceeds to pay off all of its liabilities is determined to be the value of the company. To arrive at the value of a single share of the company, all that you need to do is divide the net cash by the total number of outstanding shares of the company.
The value of a company that you derive according to this valuation model is almost always lower than that of the going concern approach. This is primarily due to the fact that when a company liquidates and sells off its assets, the resulting proceeds shall always be lower than the book value. Imagine a company selling off its assets as part of the liquidation process to be more like a discount sale.
What kind of companies is this method suitable for?
The asset-based valuation model is pretty versatile. And so, it is suitable for almost all companies, whether they’re adjudged as a going concern or in the process of winding up. Again, as with some of the other valuation methods, this model is also not as accurate as either the DCF or the DDM. Therefore, it is a good idea to combine this method with more calculated approaches to arrive at a more accurate valuation of a company.
Wrapping up
In this chapter, we’ve seen the many techniques and methods that you can use to value a company’s stock. In the forthcoming chapters, we’ll delve into the due diligence aspects of valuation, including the various factors and aspects that can affect the value of a company’s stock.
A quick recap
- The Dividend Discount Model (DDM) is a valuation technique that works on the assumption that the present value of all the future dividends of the company represent the intrinsic value of its share price.
- Since this valuation model requires you to assume that a company’s dividends would grow at a constant rate, the Dividend Discount Model only works for companies that consistently distribute dividends.
- The market value valuation method involves comparing the value of similar companies that have recently sold off to determine the value of a company.
- The asset-based valuation method involves determining the value of a company by computing its net asset value, which is the total value of assets minus the total value of liabilities.
- There are two different ways in which you can compute a company’s value using this method - the going concern approach and the liquidation value approach.
- The going concern approach assumes that the company whose value that you’re trying to determine will continue to operate in the near future without the threat of liquidation.
- The liquidation value approach works on the assumption that the company is in the process of closing down and liquidating its assets.
- The asset-based valuation model is pretty versatile. And so, it is suitable for almost all companies, whether they’re adjudged as a going concern or in the process of winding up.