Equity Valuation Fundamentals
Equity Valuation Fundamentals tests the discipline of estimating what a share is worth before comparing it with price. It covers intrinsic value, required return, forecast horizons, risk premiums, and the difference between absolute and relative approaches.
Core rules
- Intrinsic value is the present value of expected future cash flows, discounted at a rate reflecting time value and risk. Market price can differ.
- Match the cash flow to the discount rate: equity cash flows use required return on equity; firm cash flows use WACC.
- Required return can be built as risk-free rate plus equity risk premium, adjusted for beta or other risk factors. Higher risk lowers present value.
- Forecast explicit cash flows only for a period you can defend, then use a terminal value. Growth cannot exceed the long-run growth of the economy indefinitely.
- Absolute valuation uses forecasts and a discount model; relative valuation uses peer prices. They answer different questions and should be reconciled.
Worked example
A stock is expected to pay a $2 dividend and trade at $52 in one year. The required return is 10%. Intrinsic value is ($2 + $52) ÷ 1.10 = $49.09. If the market price is $50, the stock trades above intrinsic value and looks overvalued by about $0.91, or 1.9%. The expected return at $50 is ($54 ÷ $50) − 1 = 8.0%, below the 10% required return.
Traps
Do not mix forward and trailing dividends or earnings. Do not apply an equity discount rate to enterprise cash flow. Avoid using a perpetual growth rate above the risk-free rate without justification. A higher target price is not automatically a better recommendation if risk also rises.