14.2: The Philosophy of Equity Valuation
Earlier, we read that “the value of an asset is equal to the future cash flows the asset is expected to produce, discounted and aggregated to its present value.” We refer to this value or price as “intrinsic value.” This Valuation Premise shall serve as the starting point for the valuation (i.e., pricing) of equity.
In this section, we will commence with a simple example of stock valuation, one which perfectly corresponds with this statement. We shall then observe that the formulation does not conform to, or is not applicable to, many, or most, equity situations. For example, our starting point will be the application of this TVM premise to Preferred Stocks that have fixed dividends. However, what about other stocks, whose dividends are not constant? For this there will be another model, a variation on the original model.
What about investors who buy stocks for capital growth rather than income? In other words, what about investors who do not care about dividends, but instead purchase stocks for profit? Most American stocks pay no dividends at all! What are such stocks worth? For that too, we shall offer a further refinement of the original model.
To summarize, we shall systematically address shortcomings in the initial model and progressively build more comprehensive and complex models, which encompass all, or many “complaints” about the simplicity of the earlier models. Keep this in mind as we proceed down the equity valuation path.
For most things are differently valued by those who have them and by those who wish to get them:
what belongs to us, and what we give away, seems very precious to us.
– Aristotle
Nicomachean Ethics, Book IX
(F. H. Peters translation)