Valuation Techniques

There has been a lot of debate about how to value companies in hopes of finding great deal on the Street. Being a finance major, I have learned several of these ways in which to value companies. Different companies are valued different ways. One method to value a financial company may not be the same way to value an industrial company. The real problem lies with the methods themselves. Times have changed on Wall Street, but the valuation methods are staying the same.

One of the dated ways to value a company is by using the dividend discount model. I have several problems with this method. I just read a book written in 1940. The author worked on Wall Street and stated that any firms who dropped their dividend or even lowered it would be dropped from funds. Today, this would not hold true. Over half of publicly traded companies do not even carry a dividend. For these firms, the DDM is completely irrelevant. So why even use it if more than half our firms do not pay dividends? Even the firms that pay a dividend have a problem. Who is to say that one company is more valuable than another because they have a higher payout ratio? Sure, investors love companies that pay out dividends. These are normally the blue chip companies that are done growing. Why not invest in non dividend growth companies that statistically will reap greater returns? Dividends are nothing more than tax havens for the filthy rich. The majority of investors will rarely benefit from dividends given the low amount of money we put into companies.

Another method we learn is the residual income method. This is considered the method to use if nothing else works. If this is the last method to flee to, it is not going to give us a figure that is on the money. It is more of a ballpark number. Therefore, any target price we derive from this method will never be close enough to justify using it. We might as well just pick a number out of a hat.

The third method I am going to mention is the free cash flow model. I love free cash flow. This is really the only way to determine how a firm is doing and where all the cash really goes. The method merely states what the firm should be priced at given the free cash flow. It does not take into account where the cash goes. A company might look undervalued compared to this but if the cash is being wasted, obviously we do not need to invest in this company. The model does not state this so that is why it will not receive my seal of approval.

The final method (and the one I least hate) is relative valuation. This is nothing more than comparing a company to its peers. This is used in the overwhelming majority of research reports. I think the best way is to find a great industry and then look for a company with the best numbers and lowest relative ratios suggesting that it is undervalued. A company in a worst industry is never undervalued; it is always cheap.

I hate valuation methods for the most part. They all have some type of flaw. Numbers will not tell you whether the company is undervalued or just cheap. You have to look at the quantitative stuff first to determine whether the industry will hold up and cause the price to jump to where you think it should be. All of these theories are true part of the time; none of them all the time. They are, therefore, dangerous, though sometimes useful. I have never use a valuation method in my own investing techniques and I have done quite well for myself. Never let someone tell you their method is best. If it was, we would all be millionaires. There are different paths to make cash money. You just have to travel down the one you like the most.