Question

What are the different types of equity valuation models and advantages and disadvantages to them?

Answer 1

There are five types of equity valuation methods:-

1. Discounted cash flow(DCF)
2. Comparable company analysis
3. Comparable transaction comps.
4. Asset valuation
5. Sum of Parts

1. DCF :- Discounted Cash flow is net present value of cash flows presented by the company.

Advantage - DCF models tells us how much company's stock is under-valued or over-valued. and also helps us to understand whether the current stock price is justified or not.  

Disadvantage - DCF model is not suited for short term investing. Instead, it focuses on long term value creation. DCF model is quite sensitive to assumptions related to discount rate. Any minor tweaking here or there and DCF valuation will fluctuate widely.

2. Comparable company analysis :- This method involves comparing the operating metrics and valuation methods of public companies with that of target companies.

Advantage - Based on real data instead of assumptions. Easy to use and understood by investors.

Disadvantage - This method is less accurate of thinly traded stocks or volatile companies.

3. Comparable transaction comp :- Value of company using this method estimated by analyzing the price was paid by similar companies in similar circumstances.

Advantages - This valuation method saves time by using publicly available information.

Disadvantage - Most of the time amount and quality of the information related to the transactions are limited. so this will make difficult to draw any conclusions.

4. Asset Valuation :- Under this method the value of business is the difference between the value of its relevant assets and liabilities.

Advantage -This method is easy to calculate and provide a minimum value of the company.

Disadvantage - Valuation of intangible assets is difficult.and company's future earnings are ignored as well.

5. Sum of parts :- Under this method we value each business of company separately and add up the equity valuations.

Advantage - Equity valuation is usually conducted for entire enterprise. so this method helps in providing information as a whole, as the enterprises is having profit or not.

Disadvantage - This method is useful for companies whose business is concentrated in one Industry only like Apple. Not useful for companies which have diverse business interests.