Valuation Models
In the stock valuation, there are two basic models of valuation models used most frequently: (1) discounted cash flow and (2) relative valuation. If you are a beginning investor and are interested in learning what the talking heads mean as they discuss stock prices and how they come up with their targets....then this section is for you and this will hopefully serve as a nice primer. Keep in mind that these theories can take years to conquer and can be highly complex. I try to consolidate the learning curve somewhat and give you the big picture approach. After reading the synopsis below, it will all make a lot more sense when you open up the attached spreadsheets. So now on to the first model....
Discounted cash flow (DCF) is based on the time value of money.
The time value of money (TVM) concept is at the heart of finance. TVM is based on the premise that an investor prefers to receive a payment of a fixed amount today, rather than an equal amount in the future, all else being equal.
The DCF model builds a stock price under the assumption that the value of a stock is simply the sum of the future earnings expressed in present day value. In other words, since a dollar next year or anytime thereafter is not worth the same as a dollar today (today's dollar is worth more to us now then later in the future) we need to adjust it accordingly to reflect its real value as its applies to today.
In the model, all future free cash flows are estimated then discounted to give a present value. The discount rate used is generally the appropriate cost of capital and incorporates judgements of the uncertainty of the future cash flows.
DCF is a great model to find the value of an asset. However, asset values are highly contingent upon a number of factors that can be somewhat (but not always) unrealiable. First, an analyst must forecast the free cash flows of the firm for a set number of years. Second, they must correctly choose a "fair discount rate" which is to represent the opportunity cost plus risk factor.
Aside from my criticisms, DCF is still pound-for-pound the best valuation technique available. You just have to be sure that DCF fits your proposed firm and that you make you estimates are accurate as possible.
In the near future, I will be adding a podcast discussing the DCF and how investors can used a condensed version of the DCF to calculate "fair value".
Relative Valuation is a term that refers to the notion of comparing the price of an asset to the market value of similar assets. In the field of securities investment, the idea has led to important practical tools, which could presumably spot pricing anomalies. These tools have subsequently become instrumental in enabling analysts and investors to make vital decisions on asset allocation.
Many times, analysts will use a valuation matrix to compare internal financial conditions of firms. And, in some cases, this style of valuation will give you target prices just as the DCF model will provide you with.
Again, I plan to add a podcast to further discuss the mechanics of setting up a valuation matrix using relative valuation.
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