Equity valuation is the process of determining the intrinsic value of a company's stock. This is crucial for investors to make informed decisions about whether a stock is overvalued, undervalued, or fairly priced. Understanding valuation methods is a cornerstone of successful investment analysis, particularly for competitive exams like the CFA.

The primary goal of equity valuation is to estimate a stock's intrinsic value, which is the perceived true worth of the company's equity. This intrinsic value is then compared to the current market price. If the intrinsic value is higher than the market price, the stock is considered undervalued, suggesting a potential buying opportunity. Conversely, if the intrinsic value is lower than the market price, the stock is overvalued, indicating a potential selling opportunity or a stock to avoid.

Several key concepts underpin equity valuation. These include understanding the company's business model, its competitive landscape, its financial health, and its future growth prospects. Investors also consider macroeconomic factors and industry trends that can impact a company's performance. The time value of money is fundamental, as future cash flows are discounted to their present value.

There are broadly three main approaches to equity valuation: the income approach, the asset-based approach, and the market-based approach. Each approach has its strengths and weaknesses and is suitable for different types of companies and situations.

The most widely used method within the income approach is the Discounted Cash Flow (DCF) model. This model projects a company's future free cash flows and discounts them back to the present using a discount rate, typically the Weighted Average Cost of Capital (WACC). The sum of these present values, plus a terminal value, represents the estimated intrinsic value of the firm's equity.

The Dividend Discount Model (DDM) is another income-based approach that values equity based on the present value of expected future dividends. Different versions of the DDM exist, such as the single-period, multi-period, and Gordon Growth Model (constant growth DDM), each making different assumptions about dividend growth rates.

The market-based approach, often referred to as relative valuation, uses market multiples to value a company. This involves comparing the company to similar publicly traded companies (trading multiples) or to companies that have been recently acquired (transaction multiples). Common multiples include the Price-to-Earnings (P/E) ratio, Price-to-Book (P/B) ratio, and Enterprise Value-to-EBITDA (EV/EBITDA).

The asset-based approach values a company by summing the fair market value of its assets and subtracting its liabilities. This method is most relevant for companies with significant tangible assets, such as real estate firms or manufacturing companies, or in scenarios where liquidation is being considered. It's less common for valuing growth companies or those with substantial intangible assets.

Equity valuation is not an exact science. It involves making numerous assumptions about future performance, economic conditions, and market sentiment. Sensitivity analysis and scenario planning are crucial to understand how changes in these assumptions can impact valuation outcomes. Furthermore, different valuation methods may yield different results, requiring analysts to exercise judgment and consider the most appropriate approach for a given company.