Equity valuation models basically mean figuring out how much a stock is worth. It’s just a fancy term for, is the stock trading at the proper value? Is it overvalued or undervalued? When looking for a good stock to invest in for the long term, you will need to do some kind of fundamental analysis that will involve equity valuation.
In order to build a framework, I need to do a quick stock market education on something called the efficient market hypothesis first. It’s the idea that the market and individual assets are properly priced based on all of the available information. Although the market leans this way, in practice it is not this simple and clear.
The fact that the efficient market hypothesis doesn’t strictly work out means that there are times when assets can be over or underpriced. In fact, the very existence of mispriced assets are the reason why the market veer towards efficiency to begin with.
There are many different models of equity valuation for stock market investing. Most of them are those within the fundamental analysis framework, which uses information about the profitability of a company to makes it’s valuation.
In summary, some of these models include the dividend discount model, which is commonly used to price stocks. Then there are price to earnings models that analysts use. The P/E ratio and the dividend discount model are related when it comes to predicting the growth of a stock.
Then there is the free cash flow models that analysts use. This equity valuation model uses a projection and analysis of future cash flows to value a stock. There are many who believe this is the truest way to do a valuation. Once the valuation is done, you look at the market cap and see if your asset is under or overpriced.