The value of a stock can be calculated using two methods: absolute valuation models and relative valuation models.
Investors use stock valuation, free cash flow, and discounted cash flow to determine a company's value. The discounted cash flow uses a company's projected free cash flows to calculate a company's valuation. The stock valuation is the company's value divided by the number of outstanding shares. Thus, to determine a company's value, a potential investor calculates the free cash flows and discounts those cash flows at the desired discount rate to reach the company's valuation.
Stock valuation may be sorted into two primary categories: absolute valuation models and relative valuation models. Absolute valuation models determine the inherent value of a stock based on the financials of the company. The scope of absolute valuation models is limited to the individual company subject to valuation. Included in the absolute valuation models are the discounted cash flow model, residual income model, and dividend discount model.
The residual income model is a valuation method that modifies a company's forecasted earnings to adequately reflect the actual cost of equity, thus providing an appropriate value for the company. Calculating the equity charge is the first step when employing the residual income model, which is done by multiplying the total equity capital by the cost of equity. Next, residual income is computed by deducting the equity charge from the company's net income.
The residual income model shows the volume of cash flows created after the total cost of capital has been deducted. The forecasted residual income value is then discounted to the present value using the cost of capital as the discount rate. The present value of the residual incomes and the company's net value are added together to yield the actual value of the firm.
For example, a potential investor wishes to value Larry's Flower Company using the residual income valuation method. First, the investor analyzes Larry's Flower Company's annual report to identify an asset’s book value, which is equal to its carrying value on the balance sheet, in which companies calculate it netting the asset against its accumulated depreciation. Book value is also the net asset value of a company calculated as total assets minus intangible assets, such as patents and goodwill, and liabilities. Thus, in the case of Larry’s Flower Company the book value is $156,000 in 2018 and its target rate of return is five percent. A target rate of return is a desired return on investment over a specified period of time. Next, the investor projects the residual income for the next three years.
The investor expects an annual increase of 10% year over year for operating assets. Operating assets are components that are needed to generate a business and generate revenue.