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How To Select The Optimal Valuation Method To Build Better Price Targets [Part 2]

How To Select The Optimal Valuation Method To Build Better Price Targets (Part 2 of 3) by The Finance Professionals' Post

In my prior post I discussed the importance of identifying the optimal valuation method, which includes researching the valuation method used by most other equity analysts who cover the sector and stock being researched.

In this entry, I delve into the pros and cons of the most popular valuation methods. To ensure I wasn’t missing one of the more popular valuation methods, I researched the topic and came across two studies, one from the U.S. and one from the U.K. Given that buy-side analysts don’t publish their reports, these studies relied entirely on sell-side analysts and therefore they may not be representative of buy-side analyst’s work. The studies were conducted independent of one another and therefore shouldn’t be viewed comparatively. Instead, they provide an idea of the top 5 valuation methods used by equity research analysts in their respective markets. Having been based in London for part of my career, I can verify DCF is more extensively used in Europe than in the U.S.

US

Source: Information Content of Equity Analyst Reports, Paul Asquith, Michael B. Mikhail, Andrea S. Au, 2004

UK

The Use of Valuation Models by U.K. Investment Analysts. The European Accounting Review, Imam, Barker, & Chubb, 2008

Callout: If you don’t know the shortcomings of your favored valuation method, take the time to learn it or suffer the risk of a bad stock call

Just because a valuation method is widely used does that make it the best? Not necessarily, but as noted in my last entry, don’t rely on a less-used valuation method as the sole basis for a stock recommendation unless you think the market will come around to your thinking (or it yields an insight that will become apparent to those using the more commonly-accepted valuation method).

There are shortcomings to every valuation method and so none can be held up as the “best.” With that said, the closer we get to applying a multiple to the company’s free cash flows, the more likely we’ll get an accurate valuation. Here are the benefits and limitations of the most popular valuation methods:

MethodBenefitsLimitations
All Multiple-based methods below (P/E, PEG, P/S, P/B)
  • Relatively simple and quick to...

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