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Reality Check 1: Comparing market-derived and fundamentally derived values for equity

  • Wealth Management Systems Inc. Financial Communications
  • Financial Ratios
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In investing, value is a relative term. It can be derived in different ways, using either market-price ratios or a fundamental analysis of discounted cash flows, earnings or dividends. But the two methods differ significantly and rarely produce the same valuation. What’s more, within each model, there are different variations, depending upon what metric and time period is used, making for an entire spectrum of possible valuations.

In practice, equity analysts will consider several different types of valuation before coming up with their own estimated value of the security.

Market-price valuations

The principal market-price derived valuation methods look at current market price relative to earnings, sales or book value—the well-known price/earnings (P/E), price/sales (P/S) and price/book (P/B) ratios. These ratios are derived for a given time period—typically for a trailing four quarters for earnings and sales, and most recent quarter-end for book value. But ratios can also be based on longer periods or projected amounts. What’s more, the cash flows used are usually adjusted to omit extraordinary gains or losses, or to net out items that might distort their representation of the company’s recurring cash flows.

Unlike fundamentally derived valuations, market-price valuations are only relevant when compared to peers or market averages. That a given company trades at 12 times trailing fourth quarter earnings per share means nothing. But if its peers are all trading at multiples of 20 to 25, then the stock would appear to be undervalued. When using market-price valuations, it is important to compare apples to apples— make sure ratio definitions and time periods are the same for the company in question and those to whom you are comparing it. Expected growth is also a critical factor when dealing with ratios that use projected earnings. It is also important to factor in (or discount) nonfinancial events or circumstances which might affect the multiples. For instance, a large looming law suit or the approaching expiration of a patent might account for a company’s lower valuation versus its peers.

Fundamentally derived valuations

Unlike market-price valuations, fundamentally driven valuations estimate the intrinsic value of a stock by calculating its net present value. This is done by estimating the company’s future cash flows, projecting them forward, and then applying a discount rate. The discount rate is a deterministic return assumption that represents investment returns. It takes into account not just the time value of money, but also the risk or uncertainty of future cash flows. The greater the uncertainty of future cash flows, the higher the discount rate.

There are three principal types of fundamentally derived valuations: the dividend, cash-flow and earnings discount models. Each uses the respective items as a basis to project future flows. Note that such valuation techniques are complex. They entail detailed projections of the respective items and many assumptions must be made when determining an appropriate discount rate. What’s more, they only apply to certain companies. For instance, the dividend discount model can only be used for companies that pay, and have a history of paying dividends.

Which is the real value?

Consider the following hypothetical example of Company X and its estimated value using the different valuation methods.

Market-Price Derived Valuations*

  P/E Model P/S Model P/B Model
Company X Current Price $20 $20 $20
Company X earnings/sales/book value per share $1.67 $7.50 $0.64
Company X multiple (P/E, P/S, P/B) 12 2.67 31.30
Peer Average multiple 15 2.50 35.50
Company X estimated value based on peer multiple $25.05 $18.75 $22.72
Under or over-valued vs. peers Under Over Under

Net Present Value Valuations*

  Earnings Model Cash Flow Model Dividends Model
Company X Current Price $20 $20 $20
Company X earnings, cash flow and dividends per share $1.67 $7.50 $0.64
Discount rate 12 2.67 31.30
Company X estimated value+ based on respective valuation model 15 2.50 35.50
Under or over-valued vs. model estimated value $25.05 $18.75 $22.72

*Examples are hypothetical and for illustration purposes only. Net present value calculations include other variables not shown.

As in the real world, the different models produce different conclusions as to whether the stock is underpriced, overpriced or fairly priced. Keep in mind that this hypothetical illustration is simplified. Real models will adjust numbers for a host of variables and contain many underlying assumptions, which vary by analyst.

Given these disparate estimates of value, what does an investor do? In practice, it is best to consider both market-derived and fundamentally derived values when coming up with your own estimated value. What you should look for is consistency—consistency in whether the models find the stock to be under- or over-valued or fairly priced—and consistency in projected estimated value. Also keep in mind that standard valuation models work best for long-established companies with a solid track record. An emerging tech company with triple-digit sales growth and negative earnings is likely to produce wild or meaningless valuations under most of these methods, and its values are driven largely by estimates of market share or other intangibles that are difficult to quantify.

In the end, the best way to reconcile the different valuation methods is by knowing the company you are investing in—its business, financials and management. This will allow you to select or emphasize a valuation method that best suits your situation.

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Article copyright 2014 by Wealth Management Systems Inc. Reprinted with permission from Wealth Management Systems Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.