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.### Larry's Flower Company's Operating Rate of Return

Year | Calculation |
---|---|

2018 | $\$200{,}000$ |

2019 | $\$200{,}000+\$20{,}000\;(\text{or}\;10\%)\;=\$220{,}000$ |

2020 | $\$220{,}000+\$22{,}000\;(\text{or}\;10\%)=\$242{,}000$ |

2021 | $\$242{,}000+\$24{,}200\;(\text{or}\;10\%)\;=\$266{,}200$ |

Year | Calculation |
---|---|

2018 | $\$67{,}000$ |

2019 | $\$67{,}000+\$67{,}000=\$134{,}000$ |

2020 | $\$134{,}000+\$134{,}000=\$268{,}000$ |

2021 | $\$268{,}000+\$268{,}000=\$536{,}000$ |

### Larry's Flower Company's Residual Income Expectations

Year | Calculation |
---|---|

2019 | $\$134{,}000-(\$220{,}000\times0.35)=\$57{,}000$ |

2020 | $\$268{,}000-(\$242{,}000\times0.35)=\$183{,}300$ |

2021 | $\$536{,}000-(\$266{,}200\times0.35)=\$442{,}830$ |

Year | Calculation |
---|---|

2019 | $\frac{\$57{,}000}{(1+0.10)}=\$51{,}818$ |

2020 | $\frac{\$183{,}300}{(1+0.10)^2}=\$151{,}488$ |

2021 | $\frac{\$442{,}830}{(1+0.10)^3}=\$332{,}705$ |

For example, Larry's Flower Company has 100,000 shares and is selling shares at $75 per share. An investor reviews Larry's Flower Company's most recent financial statements and finds that the company's sales are $100,000, net earnings are $37,000, and book value is $156,000. The investor calculates the market capitalization of Larry's Flower Company to be $7.5 million. Market capitalization is the total dollar value of a company’s outstanding shares. With this information, the investor can calculate related ratios.

Ratio | Calculation |
---|---|

Price to Sales | $\frac{\$7{,}500{,}000}{\$100{,}000}=75$ |

Price to Earnings | $\frac{\$7{,}500{,}000}{\$37{,}000}=203$ |

Price to Book | $\frac{\$7{,}500{,}000}{\$156{,}000}=48$ |