Equity Valuation Methods

The whole unit on one sheet: technical versus fundamental analysis, the ratios, and the two intrinsic-value models the exam loves to compare.

The One-Liners That Win Points

• Technical analysis = charts, price, volume, patterns; answers when to trade, never intrinsic value.
• "All information is already in the price" is a technical assumption, not a fundamental one.
• Fundamental analysis = financial statements, ratios, and economics; answers what to buy by finding intrinsic value.
• Top-down starts with the economy, then sector, then industry, then company; bottom-up starts with the individual company. Both are fundamental.
• Dividend Discount Model (DDM) values a stock as the present value of expected future dividends; only works for dividend payers.
• Discounted Cash Flow (DCF) values a security as the present value of any expected future cash flows; works even when a company pays no dividends.
• DDM, DCF, and ratio analysis are all fundamental analysis; technical analysis is the odd one out.

Technical Analysis

• Studies past market data (primarily price and volume) to forecast future price movements.
• Does NOT analyze financial statements, earnings, management, or competitive position.
• Volume confirms price: a breakout above resistance or breakdown below support on high volume is a stronger signal than one on low volume.
• Support = price floor where buying pressure historically halts a decline; resistance = price ceiling where selling pressure historically halts a rise.
• Moving averages (for example, 50-day, 200-day) smooth price trends; relative strength compares a stock to a benchmark index.
• Technical analysts do NOT try to find undervalued stocks; they bet supply-and-demand patterns repeat.

Fundamental Analysis

• Evaluates a company's intrinsic value to judge if a stock is overvalued, undervalued, or fairly valued versus market price.
• Key ratios (learn the formula and what it measures):

• A low P/E versus peers may suggest undervaluation; a high debt-to-equity signals greater financial risk.
• P/E alone tells you nothing; compare it to industry peers or the stock's own history.

Dividend Discount Model (DDM)

• The most-tested version is the Gordon Growth Model (constant growth DDM):

Where:

• D1 = next year's expected dividend (NOT the current dividend)

• r = required rate of return

• g = constant dividend growth rate (assumed indefinite)

• Example: current dividend $2.00, growth 5%, required return 10%. D1 = $2.00 × 1.05 = $2.10; Stock Value = $2.10 / (0.10 - 0.05) = $2.10 / 0.05 = $42.00.

• Intrinsic value above market price = undervalued; below = overvalued.

• The formula breaks when g is greater than or equal to r: the denominator hits zero or goes negative, giving a meaningless result.

• Best for mature, stable dividend payers (utilities, consumer staples, financials, blue chips); does NOT work for non-dividend growth stocks or startups.

• DDM ignores capital gains; it values dividends only.

Discounted Cash Flow (DCF)

• Values a security as the present value of ALL expected future cash flows; more flexible than DDM (free cash flow, operating cash flow, earnings, or any measurable stream).
• Three steps: estimate future cash flows (often a 5-to-10-year forecast), select a discount rate (often the weighted average cost of capital, or WACC), calculate present value and sum.
• Calculated value greater than market price = undervalued (buy); less than = overvalued (sell or avoid); equal = fairly valued (hold).
• Higher risk demands a higher discount rate, which lowers present value; a safer company earns a lower rate and higher valuation.
• DCF is not limited to stocks; it works for any security with expected cash flows, including bonds and real estate.
• Garbage in, garbage out: small changes in the discount rate or growth assumptions swing the value sharply.

Numbers to Lock In

Top Gotchas

• D1 is next year's dividend. Given the current dividend, multiply by (1 + g) before plugging in; using the current dividend is the classic trap.
• Identify the method from the analyst's activity. Charts, volume, support/resistance = technical; financial statements, ratios, intrinsic value = fundamental.
• Both top-down and bottom-up are fundamental, not technical; only the starting point differs.
• DDM does not fit a company that pays no dividends (for example, a tech startup); use DCF instead.
• Technical analysis never calculates intrinsic value; if a question mentions overvalued or undervalued, it is fundamental (DDM, DCF, or ratios).
• Volume matters: a price move without strong volume is a weaker, less reliable signal.

One-Breath Recap

Technical analysis reads charts, price, and volume to answer when to trade, assuming all information is already in the price, while fundamental analysis studies financial statements and ratios to answer what to buy by finding intrinsic value. Within fundamental analysis, both top-down (economy first) and bottom-up (company first) hunt for intrinsic value, and the Dividend Discount Model prices a stock as the present value of future dividends using Stock Value = D1 / (r - g), remembering D1 is next year's dividend and the formula breaks when g is at least r. Discounted Cash Flow generalizes this to the present value of any future cash flows, so it can value non-dividend growth companies, bonds, and real estate. A calculated value above market price signals undervalued, below signals overvalued, and higher risk means a higher discount rate and a lower valuation. Lock in that DDM, DCF, and ratio analysis are all fundamental while technical analysis is the odd one out, and this unit answers itself.

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.