Stock Valuation Methods

Choosing a Valuation Method

There has always been some discussion about which valuation method is best.  Some people think that simply using multiples will give an "accurate" result.  Others say a discounted cash flow method is the only way to achieve "accurate" results.  Of course, some say that the downfall of discounted cash flow methods is that they "require precision" that isn't possible.  Most of this argument is nonsense.  None of the methods achieves "accurate" results.  There is no "precision" when predicting the future.  I think the idea of precision comes from the way finance is taught.  When learning the various methods of valuation, there is a "right" answer.  Of course, that comes from the fact that the teacher has to determine whether the student made any errors in arithmetic, since those would lead to completely fallacious results.

Another complaint about discounted cash flow methods are their supposed "complexity."  There is nothing complex about it, although you do have to keep in mind that the results are, as is the case with all valuation methods, highly subjective and the only way of knowing the "correctness" of your results is to wait and see what happens, which is likely not going to be what you thought.

In an ideal world, every valuation method would result in the same value.  But this isn't an ideal world.  Some valuation methods work well for profitable companies, some work well for start-ups, some work well for low growth while others work well for high growth.  The main thing is to make sure you understand the company you're looking at, and to make sure you understand how the market is valuing that company.  From there, stock valuation is easy.

Residual Income Method

The residual income method of stock valuation is, perhaps, one of the easiest, most direct methods to determine the value of an investment. The idea behind the residual income method is to treat the cost of equity as an actual expense and deduct that expense from net income. The resulting difference is residual income.

So, using this method, the value of a stock is the present value of the residual income, plus the current book value of equity. The residual income is discounted in the same way as in any discounted cash flow method, using the cost of equity as the discount rate. Of course, the valuation will just turn out to be the book value of equity if the company’s ROE is the same as the cost of equity. If the ROE is lower, then either the company is going to have to make some changes, or the stock price will fall below book value since the residual income will be negative.

While actual cash flows tend to be somewhat volatile, net income tends to be smoother and easier to project. Of course, this smoothing results, at least in part, from “earnings management,” which might lead some people to believe that the residual income method of valuation won’t give “accurate” results.

First, let me say this: there’s no such thing as “accurate” investment valuation. All valuation methods rely on forecasts, and those forecasts are really guesses about what’s going to happen in the future. Even the cost of equity is a guess, although a lot of finance professionals talk about it like it’s something actually knowable. The best that can be done is to estimate it.

In the end, it actually shouldn’t matter which valuation method you choose to use; they should all yield the same result. I like the residual income method because it appears that markets tend to evaluate investments largely on the basis of earnings, even though the real value is dependent more on the cash flows. In the end, it shouldn’t really matter; you can’t have net income for long without cash flows, and you can’t have cash flows without net income.