Equity Valuation Methods

Quick Answer

Two schools value stocks: fundamental analysis (financials, earnings, intrinsic value, long-term) and technical analysis (price and volume, short-term). Within fundamental analysis, ratios like price-to-earnings and price-to-book measure value, while the dividend discount model and discounted cash flow translate future cash flows into a present-value estimate of what a share is worth.

The whole unit on one sheet: the two analysis schools, the valuation ratios, the dividend discount model, and discounted cash flow.

The One-Liners That Win Points

  • Fundamental analysis examines the company (financials, earnings, assets) to find intrinsic value; it is long-term.
  • Technical analysis examines only price and volume; it is short-term and assumes price already reflects all known information.
  • Price-to-earnings (P/E) and price-to-book (P/B) are fundamental tools, never technical.
  • A high P/E signals expected growth (growth stock) or overvaluation; a low P/E signals a value stock or undervaluation. P/E is relative: compare within the same industry.
  • P/B below 1 means the stock trades below its net asset value (potentially undervalued); most useful for asset-heavy industries like banking and real estate.
  • Head and shoulders is a REVERSAL pattern (bullish to bearish); cup and handle is a CONTINUATION pattern.
  • Golden cross (short-term average crosses above long-term) is bullish; death cross (crosses below) is bearish.
  • The dividend discount model (DDM) values a stock as the present value of all expected future dividends; best for stable dividend payers like utilities.
  • Discounted cash flow (DCF) is the broader model: it uses free cash flow, so it works for any company, including non-dividend payers. DDM is a special case of DCF.

Numbers to Lock In

  • Earnings per share (EPS):
EPS=Net IncomeShares Outstanding\text{EPS} = \frac{\text{Net Income}}{\text{Shares Outstanding}}
  • Price-to-earnings (P/E) ratio:
P/E Ratio=Market Price per ShareEPS\text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{EPS}}
  • Book value per common share:
Book Value per Common Share=Total Assets−Total Liabilities−Preferred StockCommon Shares Outstanding\text{Book Value per Common Share} = \frac{\text{Total Assets} - \text{Total Liabilities} - \text{Preferred Stock}}{\text{Common Shares Outstanding}}
  • Price-to-book (P/B) ratio:
P/B Ratio=Market Price per ShareBook Value per Share\text{P/B Ratio} = \frac{\text{Market Price per Share}}{\text{Book Value per Share}}
  • Dividend payout ratio:
Dividend Payout Ratio=Dividends per ShareEPS\text{Dividend Payout Ratio} = \frac{\text{Dividends per Share}}{\text{EPS}}
  • Basic dividend discount model (no growth):
Stock Value=Dr\text{Stock Value} = \frac{D}{r}
  • Gordon Growth Model (constant-growth DDM), where D1 is next year's expected dividend, r is the required return, and g is the growth rate:
Stock Value=D1r−g\text{Stock Value} = \frac{D_1}{r - g}
  • Discounted cash flow (DCF) intrinsic value:
Intrinsic Value=∑Future Cash Flow(1+r)n\text{Intrinsic Value} = \sum \frac{\text{Future Cash Flow}}{(1 + r)^n}
  • Terminal value (post-forecast cash flows as a growing perpetuity):
Terminal Value=FCFfinal×(1+g)r−g\text{Terminal Value} = \frac{\text{FCF}_{\text{final}} \times (1 + g)}{r - g}

Top Gotchas

  • Sort the tools by school. If a question mentions charts, volume, support/resistance, or moving averages, the answer is technical. If it mentions financial statements, earnings, book value, or intrinsic value, the answer is fundamental.
  • The Gordon model breaks when g is greater than or equal to r. It produces a negative or undefined value; the model is inappropriate, not "infinitely valuable."
  • Watch D0 versus D1. D0 is the dividend just paid; D1 is next year's expected dividend. If given D0, compute D1 = D0 x (1 + g) before applying the Gordon formula.
  • Book value subtracts preferred stock first (preferred holders have a priority claim); if there is no preferred stock, that term is zero.
  • A higher discount rate lowers intrinsic value. Raise the required return without changing cash flows and the DCF valuation must fall; this is the most commonly tested DCF sensitivity.
  • Terminal value is usually the largest DCF component (often 60 to 80 percent). Both g and r sit in the denominator, so small changes move it a lot.
  • If a company pays no dividends, use DCF, not DDM. DDM needs a dividend stream; DCF uses free cash flow.

One-Breath Recap

Two schools value stocks: fundamental analysis studies the company's financials to find intrinsic value over the long term, while technical analysis studies only price and volume for short-term direction, so sort each tool to its school. Fundamental ratios include price-to-earnings and price-to-book, plus book value per share (subtract preferred stock first) and the dividend payout ratio. The dividend discount model values a stock as the present value of future dividends, with the Gordon Growth Model dividing next year's dividend by required return minus growth (and breaking when growth meets or exceeds return). Discounted cash flow is the broader model, using free cash flow for any company, where a higher discount rate lowers value and terminal value dominates the total.

Need more than the recap? This is a condensed summary. If it is not enough, read the full Equity Valuation Methods unit for the complete lesson.