An analyst sees a stock at $42 and her DCF says $58. Is the market wrong, or is her model wrong? Equity valuation is the discipline of answering that question with evidence rather than conviction.
Market price is the quoted transaction price set by the marginal buyer and seller right now. Intrinsic value is the value justified by a complete analysis of the firm's fundamentals: future cash flows, risk, and growth. The two are not the same number, and the gap is the analyst's edge.
KEY: Price is observable. Intrinsic value is estimated. The active manager's job is to estimate intrinsic value better than the market and trade the gap.
If intrinsic value exceeds price, the security is undervalued and a candidate to buy. If price exceeds intrinsic value, it is overvalued and a candidate to sell or avoid. If they roughly match, the security is fairly valued.
A perfectly efficient market collapses the two. In a strong-form efficient market, price equals intrinsic value at every instant, so analysis cannot generate excess return after costs.
Common mistakes
- Subtracting debt instead of adding it in EV. Enterprise value adds debt and subtracts cash. Trap: an answer that computes $4,800 − $2,500 − $700 = $1,600 million for EV.
- Applying DDM to non-dividend payers. Growth firms that reinvest all cash flow have DDM value of zero by construction. Use FCFE or FCFF, not DDM. Trap: "value of Amazon using the Gordon growth model."
- Treating book value as intrinsic value. Book value is a historical accounting figure, not an estimate of intrinsic value. The exam may offer book value as the "true" value for a firm. It is not.
Bottom line
- Price is what the market quotes. Intrinsic value is what fundamentals justify. A buy signal exists only when intrinsic value exceeds price by more than transaction costs and a margin of safety.
- Book value is historical-cost equity. Market capitalization is the equity claim at market prices. Enterprise value is the price of the whole firm (equity + debt − cash) to all capital providers.
- Three model families: present value (DDM, FCFE, FCFF, residual income), multiples (P/E, P/B, EV/EBITDA), and asset-based.
- Present value models are theoretically strongest but assumption-sensitive. Multiples are quick but require comparable firms. Asset-based fits resource firms and liquidations.
Exam shortcut
For the EV bridge: "Add debt, subtract cash, because the acquirer pays off debt and pockets the cash." For model selection: "DDM if it pays dividends, FCFE if it does not, asset-based if it digs things out of the ground." For the price-versus-value question: under strong-form efficiency they are equal, under semi-strong they can diverge for the analyst with private analysis, and active management is a bet on that divergence.
The full lesson (about 2,319 words, 15 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- introduction to equity valuation
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