Benefits and Limitations of Popular Valuation Methods

Details by Valuation Method

Method Benefits Limitations
• Rarely incorporates financial forecasts beyond the next 18
months
• Unlike DCF and RI (below), a company’s expected growth rate
and risk are not explicitly captured in the valuation (except for
All Multiple-
the “G” in the PEG ratio), making it difficult to compare
based
companies on these important dimensions
methods below
• Relatively simple and quick to perform • Multiple may not be computed in the same manner by all market
(all but DCF
participants; namely, the underlying financial data can be trailing,
and Residual
forward, or current year
Income)
• Other than P/E, difficult (or impossible) to analyze historical
relative valuation levels for a given stock
• Absolute multiples for individual securities do not account for
fluctuations in their overall asset class (e.g., equities)
• Understood by all because it’s the most
commonly used valuation method • Company management has more flexibility to manipulate
P/E • Can analyze historical relative earnings than cash flow
valuation levels over time (P/E relative • Does not capture cash available to shareholders
to a broad market P/E ratio)
• Incorporates earnings growth rate • Earnings growth is not the same as the more important free cash
(preferably over multiple future flow growth
periods), which makes comparisons • No widely-accepted method to compute the growth rate (next 12
PEG
among companies and, potentially months, 2 years, 3 years?)
across sectors, more plausible (but not • If using consensus estimates, it may be difficult to find reliable
perfect) long-term growth forecasts
• Unlike DCF, it considers only a one-time period of free cash flow
• Incorporates free cash flow, which is • Methodology can vary for reasons mentioned above as well as
P/FCF
the best measure of value in estimating the level of capital expenditures (maintenance vs.
forecast)
• Can be helpful if there are no earnings • Sales do not equate to free cash flow, which is the true measure
EV/S
or cash flow of value
• For most sectors, book value rarely equates to the company’s
• For select industries where assets and
market value of equity
liabilities (debt) can be valued using a
P/B • Book value can be subjectively influenced by the interpretation
public-market price, this may be a good
of accounting rules, which can make comparisons between
proxy for measuring a firm’s value
companies meaningless
• Allows for comparisons of companies
with very different capital structures • EBITDA is not a measure of the all-important free cash flow or
EV/EBITDA
• Can be helpful when a company does earnings
not generate pre-tax income
• Dividends are not the same as free cash flow, although they can
• Can be helpful to measure a floor when
Dividend yield move in tandem over the long run
stocks collapse
• Difficult to forecast when management will cut a dividend

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 Benefits and Limitations of Popular Valuation Methods
Method Benefits Limitations
• Capture a company’s ability to
generate free cash flow over the life of • Can be highly sensitive to minor input changes for factors often
the enterprise, which is the best difficult to quantify
measure of value • Time-consuming because multiple periods are required for
• Helps to place the focus on the level of, forecast
DCF and RI
and returns from, incremental capital • Complex models are prone to mistakes and reverse engineering
spending (ROIC) • During times of highly-priced equity markets, it may be
• More likely to identify overheated and challenging to find attractive equity investments using these
oversold stocks and markets than methods
multiples-based methods

Comparison of Valuation Methods by Specific Criteria

EV/
Relevance* P/E PEG P/FCF DCF P/B EV/S Dividend Yield
Benefit EBITDA
Good proxy for free cash flow to
3
shareholders
Captures multi-period growth 2
Relatively simple and quick to perform
2
(low risk of mistakes)
Can be utilized when comparing
1
companies not in the same sector
Captures risk/volatility 1
Eliminates potential effects of
management using aggressive accounting 1
tactics (not fraud)
Not overly-sensitive to minor changes to
1
assumptions
Allows for accurate valuation of company's
0
assets at current market prices
Helpful in identifying attractively valued
0
stocks in an overheated market
In general, computation is consistent by all
0
market participants
Useful if there are no earnings or cash flow
0
during the forecast period
Total, weighted

= Always or = Rarely or
= Sometimes
almost always never meets
meets criteria
meets criteria criteria
* Relevance in helping accurately measure long-term free cash flow on a regular basis for multiple stocks

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