Valuation Techniques: Discounted Cash Flow, Earnings Quality, Measures of Value Added, and Real Options

CHAPTER 7

TRADITIONAL EQUITY VALUATION METHODSa

Thomas A. Martin Jr., CFA

Traditional equity valuation methods are simply ways of exercising the critical judgment needed to determine value between the extremes of “cheap” and “expensive.” Whether used for screening purposes or for fundamental analysis, such methods allow investors to make rational and consistent assessments of potential changes in key valuation inputs.

Valuation is all about judgment. At the extremes of cheap or expensive, value is obvious, but between those extremes, analysis and judgment are crucial for determining value. Traditional equity valuation methods are simply ways of performing analysis and exercising judgment. None of these methods consistently works particularly better than any of the others, and to a certain degree, they tend to give similar buy/sell signals for specific stocks. Still, these traditional methods are useful for thinking about stocks and what should drive buying and selling decisions.

Although the traditional valuation methods are relatively simple, their compelling advantage is that analysts understand what these methods are indicating. Most of the time when an analyst or a portfolio manager talks about valuation, stock selection, or the investment process, the decision ultimately comes down to picking cheap stocks. Stocks are considered cheap on some basis. When that basis is not something complex and sophisticated—such as franchise value or firm value or economic value added or some ...