valuation models

Valuation Models: What Are They And How To Use Them In Stock Analysis?

Uncategorized 30 December 2023 5 Mins Read

With the help of valuation models, an investor can determine the present value of a company, an asset, or an investment. Before placing value on an asset, investors and analysts normally look at the prospective future earning potential of the company or the asset. Hence, valuation models allow investors and analysts to find out the projected worth of an asset or a company.

In this article, you will learn about what is valuation in the context of investments. Apart from that, you will also find out about the different categories of valuation models and how they work. Finally, we will discuss the most popular types of valuation models that investors and business analysts use to determine an asset’s worth. Hence, to learn more, read on through to the end of the article.

Valuation Models: A General Overview

According to Harvard Business School,

Company valuation, also known as business valuation, is the process of assessing the total economic value of a business and its assets. During this process, all aspects of a business are evaluated to determine the current worth of an organization or department. The valuation process takes place for a variety of reasons, such as determining sale value and tax reporting.”

There are a lot of valuation models available for investors, which they can use to find the value of a stock for the first time. However, many investors and analysts become overwhelmed by the sheer number of valuation models. While some models are fairly straightforward, there are some that are more involved and complicated.

However, the valuation method that you use depends a lot on the situation you are facing at the given moment.

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What Are The Different Categories Of Valuation Models?

According To Investopedia,

There are valuation methods that are fairly straightforward, while others are more involved and complicated. Unfortunately, there’s no one method that’s best suited for every situation. Each stock is different, and each industry or sector has unique characteristics that may require multiple valuation methods. In this article, we’ll explore the most common valuation methods and when to use them.”

The following are the two major categories in which various valuation methods fall:

Absolute Valuation

These types of valuation models try to find the intrinsic value or “true” value of an investment. Hence, these models base their processes only on fundamentals. If you look at only fundamentals, it simply means that you focus on only things like cash flow, dividends, growth rate, etc., of a single company.

The following are the most popular valuation models that fall under absolute valuation:

  • Dividend Discount Model
  • Asset-Based Model
  • Residual Income Model
  • Discounted Cash Flow Model

Relative Valuation

In this case, the valuation models compare the data of a given company with other companies that are performing well. With these methods, you will need to calculate multiples and ratios and compare these ratios to the multiples of similar companies.

In most cases, the ratio that investors find out is the price-to-earnings ratio. These models are easier and quicker to calculate as compared to absolute valuation models. Hence, these models are more popular among investors.

What Are The Most Popular Valuation Models?

According to CFAInstitute.org,

When valuing a company or group of companies, the analyst wants to choose a valuation model that is appropriate for the information available to be used as inputs. The available data will, in most instances, restrict the choice of model and influence the way it is used. […] A model should be kept as simple as possible in light of the available inputs.

Popular Absolute Valuation Models  

The following are the popular absolute valuation models among analysts and investors:

1. Dividend Discount Model

It is one of the most basic valuation models that investors and analysts use to value an asset or a company. With this model, investors calculate the true value of a firm based on the company’s dividends that it pays to its shareholders. The dividends of a company represent the actual cash flows that go to the shareholders.

2. Discounted Cash Flow Method

This method is a great option if you are not sure how the company pays its dividends. In this case, the investors use the company’s discounted future cash flows to value its business. Since one can use this valuation method with a wide variety of firms, this method can actually be advantageous.

Popular Relative Valuation Models

The following are some relative models that are popular among analysts and investors:

1. The Comparables Model

This valuation model is the best option for you if you do not want to deal with numbers for a long time. However, you must use this model if you are unable to use any other models to value an asset or a company. It basically compares the stock price multiples of various companies to determine whether the stock is overvalued or undervalued.

2. Precedent Transaction Method

With this method, you can compare the value of a company with that of other similar companies. However, you will need to make sure that the companies are sold recently. Basically, this comparison works best if companies are in the same industry. This transaction method works best in the case of mergers and acquisition transactions.

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Summing Up

Hope this article was helpful for you in getting a better idea of various valuation methods that investors and analysts use. These methods are helpful to find out the present and future value of a company or an asset. The valuation provides prospective buyers and investors with the idea of how much they should pay for an asset or a company.Which valuation model do you think best suits your case? Consider sharing your ideas and opinions with us in the comments section below.

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A passionate writer and an avid reader, Soumava is academically inclined and loves writing on topics requiring deep research. Having years of content writing experience, Soumava also loves creating blogs in other domains, including digital marketing, business, technology, travel, and sports.

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