Equity Valuation Process and Framework: Valuation Methodologies and Techniques

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Task 1
Process and framework of equity valuation
The term valuation refers to the computation of the estimation of the worth of an asset or a
security or a business by an existing or a prospective investor. The investors are interested in
knowing the valuation of the security or a business before purchasing the portion of the said
assets or security. The valuation exercise involves the valuation of tangible assets such as
plant, machinery, equipment, furniture, as well as that of intangible assets such as patents,
copyrights, good will. It is however significant to note that the valuation process is a
subjective process and involves a number of assumptions. Some of the concepts that are used
in the valuation of the equity stock are explained as follows.
Book Value: Book Value is the accounting record of the assets, as are shown in the balance
sheet. The valuation is used as part of the going concern principle of accounting. The
valuation is arrives by deducting the accumulated depreciation from the purchase cost of an
asset.
Market value: Market value refers to that value in the market at which an asset or an equity
security of a company can be sold. The valuation can be assigned only to the tangible assets
and securities, as the intangible assets are not sold in the market.
Intrinsic/Economic value/ discounted value: This is arrived by application of an an
appropriate discount rate and then discounting the incremental cash flows. The discounting
rate is one as decided by an investor. The decision of the choice of the discount rate is
dependent on the discretion of the expertise and analysis of the investor. This is also stated to
be the maximum value at which a business can be acquired.
Liquidation value: This is calculated only at the time of the liquidation of the entity. It is
represented by the price at which each of the individual asset can be sold, when the business
is liquidated. It is valued after deducting all the external liabilities. This is the least valuation
of the stock.
Comparison and analysis: The investor makes a comparison of the value of the stock using
various methodologies and the prices at which shares are traded. In addition, the investor
indulge in the analysis of the financial statements of the entity, and that of the macro
environment including the competitors data to arrive at a decision.

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Thus, it can be stated that depending upon the type of valuation, one or more of the concepts
are used.
Valuation Methodologies
The key assumption that is being applied in the case of equity valuation is that it is dependent
upon the fundamentals of the firm’s underlying business. Some of the valuation
methodologies of the valuation of the equity stock are described as follows. There are three
main approached prescribed for the valuation of the equity stock that is the balance sheet
values, discounted cash flow (DCF), and the comparable approach. While the balance sheet
values refers to the computation of the value of the stock referring to the book
value, liquidation value, and replacement value methods; the discounted cash flow
methodology involves the dividend discount models, constant growth model, and free cash
flow models. The comparable approach or the relative approach is referred to as the
calculation of the various ratios such as the price to book value ratios, price to earnings ratios,
price to sales ratios and others.
Dividend discount valuation model
The dividend discount model represents that the value of a stock is equal to the sum of all the
future dividends of an enterprise. Out of all the models, the most popular one is referred to as
the Gordon Growth Model. Some of the key assumptions on which the said model operates
are described as follows.
First is the approximation of the values of the future dividends. The payout ratio of the
dividend may not be the same and depends on a number of incidental factors, which makes it
difficult to arrive at the figures of the future dividends.
Second key assumption is the determination of the discount rate for future payments. This
rate is described as rate at which the amounts received from the investments are reinvested.
The investments here refer to the investments in stock, as well as in debt. Thus, this rate is
difficult to compute.
The formula for the dividend discount model is listed as follows.

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Here, P is the present value of the stock,
Div = dividends that are paid out to the investors for a given year,
R= the required rate of return expected by the investors in light of the risk associated of the
said investment.
The key steps of the formula are listed as follows. Firstly, the future dividends are calculated
as per the current dividend rate and applying the rate of inflation. Secondly, the rate of return
as determined by the investor as per risks involved in the investment is used to discount all
such future dividends that are expected to be received. The price or the value of the equity
stock is the sum of all such discounted present values.
Comparison of Various Methods
While the first set of the methods are focussed on the values of assets or securities as
represented in the financial statements or the markets, the second method involves the use of
growth rate and discount rate. The third method involves mix of various components of first
method to compute the various ratios.
The first set of techniques take into account the various elements of the books of accounts is
done. Thus, the first method involves the use of the either the past figures or the current
figures. Analysis is done by comparing the data of the competitors. The strength lies in the
simplicity. In addition, there is the accuracy of information as obtained form company data or
the stock market. The disadvantage of the method is that these do not take into consideration
the possible future evolution or the time value of money. In addition, another disadvantage is
that the factors like capability of the human resources, organisational problems, and the
current industrial scenario are not taken into account.
The second method involves the computation of discounting rate and applying the same to
various formulas. Some of the formulas are dependent upon the divided, while some on
profits or earning per share to equity shareholders. The strength of method is that these
provide the closest estimate of a stock’s intrinsic value. While the growth rate and
discounting rate are computed taking into consideration the current market risks and
scenarios, these methods are subjective. Two investor for same category of stock may have