How do those whose jobs involve stock valuation perform this task? In their September 2015 paper entitled “Equity Valuation: A Survey of Professional Practice”, Jerald Pinto, Thomas Robinson and John Stowe report results of a 38-question equity valuation practices survey sent to 13,500 CFA Institute members with equity analysis job responsibilities. They guided respondents through the survey via the following introductory question:
“In evaluating individual equity securities, which of the following approaches to valuation do you use? (Select all that apply)
a) A market multiples approach (e.g., based on price-to-earnings, enterprise value-to-EBITDA, or other multiples)
b) A present discounted value approach (e.g., based on forecasts of future dividends, free cash flows, or economic value added/residual income)―also known as the income approach
c) An asset-based approach (e.g., based on book value, adjusted book value, asset market values, or asset replacement costs)
d) A (real) options approach (using options models to value equity)
e) Other (please specify)”
Using responses from 1,980 completed questionnaires, they find that:
- 66%/12%/22% of respondents are from the Americas/Asia-Pacific/Europe-Middle East-Africa, respectively.
- Respondents spend an average (median) of 62% (70%) of their work week evaluating individual stocks.
- Approaches a), b) and c) as defined above dominate valuation practices, led by market multiples and present discounted value.
- Hedge funds used an asset-based approach more frequently than a present value approach.
- Brokerage firms and investment banks use a present discounted value approach much more frequently than do hedge funds.
- Valuation methods used vary by industry/sector.
- For the market multiples approach:
- P/E is the most widely used market multiple, followed closely by enterprise value multiples (such as EV/EBITDA) and more distantly by P/B and P/CF.
- Forward-looking P/E is much more used than trailing P/E, and net income is much more popular than operating income as an earnings metric.
- EV/EBITDA is overwhelmingly the most popular enterprise value ratio.
- For the present discounted value approach:
- There is an overwhelming preference for using free cash flow.
- Portfolio managers use a dividend discount model more frequently than do analysts.
- In estimating the required return on capital, the capital asset pricing model (CAPM) is most popular, followed by judgment and the bond yield plus a risk premium.
- Historical or adjusted historical estimates are most widely used for the equity risk premium.
- The average (median) number of forecasted years is eight (five) for cash flow and seven (five) for dividends.
- There is little variation in valuation practices based on personal characteristics (years of experience, highest academic degree, accounting designations, years holding the CFA charter and charter versus non-charter).
In summary, a survey of stock valuation professionals indicates that P/E, EV/EBITDA, present value of discounted cash flow and value of assets are the principal means of evaluating stocks.
Cautions regarding findings include:
- Findings reflect preferences in practice, not tests of method accuracies.
- Other groups may have other preferences.
For reference, see “Classic Paper: Company Valuation Methods”.
Frequently Asked Questions
What is equity valuation and what are the main approaches professionals use?
Equity valuation is the process of estimating the worth of an individual stock, and professionals mainly use market multiples (such as P/E or EV/EBITDA), present discounted value (based on forecast dividends, free cash flows, or residual income), asset-based approaches (such as book or replacement value), and, less commonly, real options models. In a 2015 CFA Institute survey, the first three approaches dominated practice, led by market multiples and present discounted value.
Which stock valuation methods do investment professionals use most often?
Market multiples and present discounted value approaches are the most widely used stock valuation methods among professionals, with asset-based approaches also common. In a survey of 1,980 CFA Institute members with equity analysis responsibilities, P/E was the most widely used multiple, followed closely by enterprise value multiples such as EV/EBITDA. Usage varies by industry/sector and by employer type, but little by personal characteristics such as experience or education.
How do analysts estimate the required return and forecast cash flows in a discounted cash flow valuation?
In the surveyed discounted cash flow practice, analysts overwhelmingly prefer free cash flow, and the capital asset pricing model (CAPM) is the most popular way to estimate required return on capital, followed by judgment and bond yield plus a risk premium. Historical or adjusted historical estimates are most widely used for the equity risk premium. The average (median) forecast horizon is eight (five) years for cash flow and seven (five) years for dividends.
How do hedge funds, brokerages and portfolio managers differ in their stock valuation methods?
Valuation practice differs by employer and role in the CFA Institute survey. Hedge funds used an asset-based approach more often than a present value approach, while brokerage firms and investment banks used present discounted value much more frequently than hedge funds. Portfolio managers used a dividend discount model more often than analysts did.
Does the popularity of P/E and DCF valuation mean these methods are the most accurate?
No, the popularity of P/E, EV/EBITDA and discounted cash flow methods does not show they are the most accurate, because the survey findings reflect preferences in practice, not tests of method accuracy. The results also come from 1,980 CFA Institute members (66% from the Americas), so other groups of investors may have different preferences.