Equity Valuation Methods
Investment advisers use various methods to determine whether stocks are fairly valued. Understanding these valuation techniques is essential for making investment recommendations and is heavily tested on the Series 65 exam.
Two Approaches to Valuation
Fundamental Analysis
Fundamental analysis examines a company's financial statements, economic conditions, and business prospects to determine its intrinsic value.
- Analyzes earnings, revenue, assets, and liabilities
- Considers industry conditions and competitive position
- Projects future cash flows and earnings
- Compares intrinsic value to market price
Technical Analysis
Technical analysis studies price patterns, trading volume, and market trends to predict future price movements.
- Charts and trend analysis
- Support and resistance levels
- Moving averages and momentum indicators
- Ignores fundamentals—focuses only on price and volume
Most questions on the Series 65 focus on fundamental analysis and specific valuation ratios.
Price-to-Earnings Ratio (P/E)
The P/E ratio is the most widely used valuation metric. It shows how much investors are willing to pay for each dollar of earnings.
Formula
P/E Ratio = Market Price per Share ÷ Earnings per Share (EPS)
Types of P/E
| Type | Uses | Advantage |
|---|---|---|
| Trailing P/E | Past 12 months actual earnings | Based on real numbers |
| Forward P/E | Estimated future earnings | More forward-looking |
Interpreting P/E
| P/E Level | Typical Interpretation |
|---|---|
| High P/E (20+) | Growth expected; investors pay premium |
| Low P/E (<15) | Value stock; slow growth or problems |
| Negative P/E | Company has losses; P/E not meaningful |
In Practice
A company with a P/E of 25 means investors pay $25 for every $1 of current earnings. If the industry average is 18, the stock is trading at a premium—either the market expects higher growth, or the stock may be overvalued.
Limitations
- Cannot use when earnings are negative
- Earnings can be manipulated through accounting choices
- Doesn't account for differences in growth rates
Price-to-Book Ratio (P/B)
The P/B ratio compares market value to accounting (book) value.
Formula
P/B Ratio = Market Price per Share ÷ Book Value per Share
Where: Book Value = (Total Assets - Total Liabilities) ÷ Shares Outstanding
Interpreting P/B
| P/B Level | Interpretation |
|---|---|
| P/B < 1 | Stock trades below book value; may be undervalued |
| P/B = 1 | Stock trades at book value |
| P/B > 1 | Market values company above accounting value |
Best Use Cases
- Financial institutions (banks, insurance companies)
- Asset-heavy companies (real estate, utilities)
- Distressed or cyclical companies
On the Exam
A P/B ratio below 1.0 doesn't automatically mean "buy"—it may indicate the market expects write-downs of assets or future losses. Always consider why a stock trades below book value.
Price-to-Sales Ratio (P/S)
The P/S ratio compares stock price to revenue rather than earnings.
Formula
P/S Ratio = Market Price per Share ÷ Revenue per Share
Or: Market Capitalization ÷ Total Revenue
Advantages
- Can use when earnings are negative
- Revenue is harder to manipulate than earnings
- Useful for young or high-growth companies
Limitations
- Ignores profitability completely
- Industry-specific (compare within same industry)
- Low-margin businesses have low P/S by nature
PEG Ratio
The PEG ratio adjusts P/E for expected growth, making it useful for comparing companies with different growth rates.
Formula
PEG Ratio = P/E Ratio ÷ Expected Earnings Growth Rate (%)
Interpreting PEG
| PEG | Interpretation |
|---|---|
| PEG < 1 | Stock may be undervalued relative to growth |
| PEG = 1 | Stock fairly valued relative to growth |
| PEG > 1 | Stock may be overvalued relative to growth |
Example
| Company | P/E | Growth Rate | PEG |
|---|---|---|---|
| Company A | 30 | 30% | 1.0 |
| Company B | 15 | 10% | 1.5 |
Despite a higher P/E, Company A has a lower PEG and may be the better value when considering growth.
Dividend Discount Model (DDM)
The Dividend Discount Model values a stock as the present value of all expected future dividends.
Basic DDM Formula
Stock Value = D₁ / (r - g)
Where:
- D₁ = Expected dividend next year
- r = Required rate of return (discount rate)
- g = Expected dividend growth rate (must be < r)
This is also called the Gordon Growth Model or Constant Growth Model.
Example
A stock pays a $2 dividend expected to grow at 5% annually. The required return is 12%.
D₁ = $2.00 × 1.05 = $2.10
Value = $2.10 / (0.12 - 0.05) = $2.10 / 0.07 = $30.00
If the stock trades at $25, it may be undervalued. If it trades at $40, it may be overvalued.
Assumptions and Limitations
| Assumption | Limitation |
|---|---|
| Dividends grow at constant rate forever | Few companies maintain constant growth |
| Growth rate is less than required return | Model breaks if g ≥ r |
| Company pays dividends | Cannot use for non-dividend stocks |
| Dividends reflect value accurately | May not apply to growth companies |
On the Exam
The DDM is most appropriate for:
- Mature, stable companies
- Companies with consistent dividend history
- Utility stocks, blue-chip stocks
- Companies with predictable earnings
The DDM is NOT appropriate for:
- High-growth companies reinvesting earnings
- Companies that don't pay dividends
- Cyclical companies with volatile earnings
Discounted Cash Flow (DCF) Analysis
DCF analysis values a company based on the present value of projected free cash flows.
Basic Approach
- Project free cash flows for a forecast period (5-10 years)
- Calculate terminal value at end of forecast period
- Discount all cash flows to present value at required return
- Sum = Intrinsic value of the company
Free Cash Flow vs. Dividends
| Model | Uses | Best For |
|---|---|---|
| DDM | Dividends only | Dividend-paying stocks |
| FCF Model | Operating cash flows | All companies, control perspective |
DCF is more flexible than DDM because it can value any company regardless of dividend policy.
Relative Valuation
Relative valuation compares a company to peers using multiples.
Common Comparable Multiples
| Multiple | Calculation | When to Use |
|---|---|---|
| P/E | Price / EPS | Profitable companies |
| EV/EBITDA | Enterprise Value / EBITDA | Capital-intensive businesses |
| P/B | Price / Book Value | Financial firms, asset-heavy |
| P/S | Price / Sales | High-growth, unprofitable |
Process
- Identify comparable companies (same industry, size, growth)
- Calculate multiples for all comparables
- Apply average or median multiple to target company
- Estimate target's intrinsic value
Key Takeaways
- P/E ratio is most common; higher P/E suggests higher growth expectations
- P/B ratio compares to accounting value; useful for asset-heavy companies
- P/S ratio works when earnings are negative; compare within industry
- PEG ratio adjusts P/E for growth; PEG < 1 may indicate undervaluation
- Dividend Discount Model values stock as PV of future dividends; requires stable, dividend-paying company
- DCF analysis is more flexible; works for any company with projectable cash flows
- Always compare valuations to industry peers and historical averages
The dividend discount model (DDM) is most appropriate for valuing:
A company has a stock price of $50, EPS of $2.50, and expected earnings growth of 10%. What is the PEG ratio?
Using the Gordon Growth Model, what is the value of a stock that currently pays a $3.00 dividend, has a required return of 11%, and an expected growth rate of 5%?
5.5 ADRs, REITs & Other Equity Securities
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