In the 1970s, a group of "buy-and-hold' stocks known as the "nifty fifty" were market darlings whose rapid growth was sufficient to convince investors that it was inevitable that the stocks would provide market-beating results despite their high prices, short operating histories and sparse profits. The unanticipated 1972-1974 market collapse, however, taught "nifty-fifty" investors that, when valuing a stock, investor psychology should be set aside, and economic analysis should take center stage.
While there is no one stock valuation method that is suited for any and all situations, some are more suited for the stocks of one industry rather than those of another. Still others base a company's intrinsic value on information that appears on its financial statements, rather the evaluation of a company's operating results relative to that of its peers. To ensure your stock valuation efforts yield accurate results, it's important to select a valuation model that's suitable and capable of meeting your goals.
Types of Valuation Models
Typically, a valuation model is either an absolute valuation model or a relative valuation model.
A relative valuation model compares one company's value to that of others that operate in the same industry and offer competing products and services. This to assess an organization's relative financial worth. Relative valuation models are useful when the need exists to calculate and compare multiples – the division of a company's market value by a certain line item of company's financial statement, such as earnings before interest, taxes, or depreciation and amortization.
Also, the models are helpful in comparing one company's financial statement ratios – such as the price-to-earnings (P/E) ratio, price-to-free-cash (PFC) ratio, enterprise value (EV) ratio and operating margin (return-on-sales or ROS; OM) ratio – to that of other companies.
An absolute valuation model uses fundamentals, such as a company's dividends or cash flow and growth rates to determine its "true" or intrinsic value. Such models include the dividend discount model (DDM,) residual income model (RIM,) the discounted cash flow model (DCF) and the asset-based model (AS). Information about the asset-based model, in particular, follows.
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What Is the Asset-Based Model?
The asset-based model is an absolute valuation model that calculates a company's net asset value, or a stock's per share market value. The net asset value, or book value, is calculated by subtracting a company's total liabilities from its total assets. The company's net asset value per share equals the company's net asset value divided by the total shares outstanding.
Essentially, a company's book value is the price a buyer must pay to purchase the business, or the company's sales price. For instance, if a company's assets are valued at $6 million, but its liabilities equal $3 million, the company's book value is $3 million.
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Change in Elements of Asset-Based Model
A company's net asset value fluctuates over time due to an increase or decline in the value of a company's assets in qualitative, quantitative or technical terms. For instance, the company's net asset value will shift as it buys or sell assets.
The Purpose of an Asset-Based Model
The policies of a company's executives are influenced by a company's value and the shifts in that valuation over time in that investor returns tend to increase when a company's value rises. In an effort to increase a company's net asset value, executives might adjust the qualitative factors that influence net asset value, such as the company's business model, its target markets or the mechanisms that control a company's operations.
Likewise, executives might respond to a large shift in the company's net asset value by prioritizing a focus on quantitative performance measures that affect investor perceptions of the company's worth.
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Issues With the Asset-Based Model
A company's assets and their values fluctuate over time, a fact that poses a problem with the use of the asset-based model. The issue is in part due to the fact that the calculation of a company's book value or fair market value is unlikely to equal the valuation of those assets as documented in a company's balance sheet.
What's more, adjustments to a company's assets as measured with the asset-based model may exclude intangible assets that aren't fully recognized in a company's financial statements. For instance, a balance sheet may not reference trade secrets or other intangibles even though the value of those assets may be significant. Consequently, the use of the asset-based model to underscore the negotiations for the sale of the company may not be advisable.
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.