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Investment Analysis Demystified: Valuation Methodologies

Using valuation metrics when studying companies as potential investments can be key, but there are different types of methodologies in use by brokerage sell-side analysts to justify a company’s fair value. Back-of-the-envelope methods of valuation using the price-to-book or price-to-earnings ratios are both easy to understand and easily applied by investors.

However, in order to get a better grasp of what analysts are talking about, and also to more fully appreciate how a company’s value is derived, we need to look at the different ways of valuing companies using financial models. Investors can then make their own conclusions as to the appropriateness of each method based on the characteristics of each company. Though brokerage reports ought to be taken with a pinch of salt anyway, investors can go a step further by disregarding methods that are clearly out of sync with reality.

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Here’s a rundown of some of the more common methodologies used, as well as their pros and cons.

Discounted cash flow (DCF)

This is one of the most common financial models used in the asset management industry. It’s essentially a method to project the value of the company back to the present using future projected free cash flow. While this method is technically accurate, the devil is in the details, and forecasts could easily overstate or understate the actual cash flow, resulting in misleading conclusions.

This method has also been criticised for an over-reliance on the “terminal value,” which projects a company’s ability to grow in perpetuity based on a growth factor (e.g., 2%). Most of the value of the company may hinge on this terminal value, which then makes the entire model extremely sensitive to changes in assumptions.

Dividend discount model (DDM)

The dividend discount model relies on the regularity of dividend payouts in order to derive the value of the business. This model is obviously most applicable to companies with predictable and stable dividend payments, and it would be most suitable for use in real estate investment trusts or utility companies (which have predictable, locked-in revenue).

Each dividend is discounted back to the present using a discount rate (this is the rate at which funds are expected to grow if deposited in safe securities), and the total is then tallied up to arrive at the value of the company. Needless to say, the reliability of this model depends greatly on the sustainability and growth of the dividends paid out.

Sum of the parts (SOTP)

Sum of the parts is technically not a methodology on its own, but it simply represents the totalling up of various components of a company that have been valued separately. This method applies to large, sprawling conglomerates that have multiple, disparate divisions. Each division is then valued according to DCF or DDM, or based on asset values or earnings multiples. The total valuation for the conglomerate is then the sum of each “part,” with an appropriate discount applied to the total to reflect the complexity of the organisation’s structure. The downside to this method is, of course, the inherent complexity of the calculations as well as the various assumptions used to value each separate part.

The Foolish bottom line

Remember that no one method is best, and investors may wish to play around with a variety of methods to see what values they get, and then weigh each method accordingly for suitability. An example might be 70% DDM, 20% DCF, and the remainder using net asset value. This smoothens out the errors, and investors are not over-reliant on any one valuation methodology.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.