Do you wonder how ace investors always select the best stocks? How do they know which stock values will rise in due course? They use a process of stock valuation, which discovers the intrinsic value of stocks. If you want to earn market-beating returns on your investment, you must master the stock valuation skills. It will help find if a stock is overvalued or undervalued at its current market price.
Stock valuation is an art backed by science. We will discuss the types and methods of stock valuation and how you can base your decisions on stock valuations.
What is Stock Valuation?
Stock valuation is the single most crucial skill that investors need to master to determine if a stock is currently overpriced or underpriced concerning a company’s performance and growth projections.
The intrinsic value, measured based on business fundamentals, may or may not match the current market price, which is an outcome of demand and supply factors. Applying stock valuation helps determine the fair price of a share. Active investors believe that the intrinsic value of a stock is separate from its current price, and hence, apply a series of metrics to compute its real value to compare it against market price.
However, another set of investors, called passive investors, base their argument on the efficient market hypothesis, meaning that market price is based on all available information. Hence, it is the actual value of the stock. The passive investing theory recommends investing in index funds or ETFs that reflect market returns rather than calculating a different value of a stock to outsmart the market.
Stock valuation is a complex process and could be overwhelming to an investor. Hence, investors should be able to focus on relevant information and filter noise in the process. Knowledge of basic types of valuation and methods is necessary.
Types of Stock Valuation
There are two primary types of stock valuation methods: Absolute and Relative.
Absolute
The absolute method of stock valuation relies on the fundamental analysis of a business. It bases valuation on various financial information derived from financial statements, focusing on metrics like cash flow, dividend, and growth rate.
Calculating a stock’s value using the absolute method involves computation of dividend discount model (DDM), discounted cash flow model (DCF), residual income model, and asset-based model.
Absolute method, as the name suggests, doesn’t compare the company’s performance with peers.
Relative
The relative valuation method involves comparing significant financial ratios of similar companies and deriving the same metrics for the company in focus. The popular way is comparable companies analysis.
Calculating the P/E ratio forms the cornerstone of the relative valuation method. For instance, if the P/E ratio of the current company is less than its peer, then its stocks are undervalued.
Let’s understand with an example. Company A reported diluted earnings per share for the fiscal ending in January 2021 as Rs 6.76 and price at the time of calculation, Rs 203. To obtain a P/E ratio, we will divide the share price by EPS.
P/E = (Rs 203/ 6.76) = Rs 30.03.
One can easily obtain EPS value from a company’s financial statements and price is the current value of its shares in the market.
Common Stock Valuation Methods
Let’s now see what popular stock valuation methods you can apply.
Dividend Discount Model (DDM)
The dividend discount model is an accepted method for calculating the absolute value of a stock. It calculates the actual price based on the dividends the company pays to its shareholders. Analysts argue that dividends represent the genuine cash flow of the business going to its shareholders, and calculating the present value of future dividend payment should give the correct worth of the stock.
Large corporations, which pay regular dividends at a stable rate are best suitable for DDM valuation. Next, investors apply the GGM or Golden Growth Model, assuming a predictable dividend growth rate. It is a straightforward method and takes away the complications of variable dividend payout.
Discount Cash Flow Model (DCF)
When a company doesn’t pay a dividend or has an irregular dividend model, investors use a discounted cash flow model, which bases its calculation on discounted future cash flow instead of dividend rate.
The discounted cash flow model can be applied to a wide range of companies that are not blue-chip, including those which don’t pay any dividend.
There are several ways available to calculate DCF. However, the most popular is the two-stage DCF model, where investors first calculate free cash flow forecasted for five to ten years and then measure terminal value for all the cash flows beyond the forecasted period.
To efficiently calculate valuation based on the DCF model, companies must have stable and predictable free cash flow. Thus, mature companies past the growth stage are considered the ideal candidates for DCF valuation.
The Comparable Analysis
The comparable analysis compares different crucial financial ratios between companies to determine the true worth of stocks. It includes comparing values like the P/E ratio, price to book ratio, and EBITDA. It is based on the ‘law of one price’ principle, which proposes that two similar assets should have the same price, deviation from this fundamental suggests undervaluation or overvaluation.
A comparable analysis is one of the simplest methods of stock valuation that anyone can apply.
Comparing the P/E ratio forms the cornerstone of stock valuation. P/E ratio represents the company’s stock price divided by the most recent reported earning per share (EPS). A low P/E ratio makes a stock attractive to investors.
P/E Ratio Forms the Basis of Stock Valuation Theory
The most common way of valuing a stock is by calculating the price-to-earnings ratio. The P/E ratio is a valuation of a company’s stock price against the most recently reported earnings per share (EPS). Investors use the P/E ratio as a yardstick to measure a company’s stock value. A higher P/E ratio would imply overvalued shares. Conversely, a low P/E, when compared against peers and the broader market, indicates undervalued shares. Value investors constantly look for undervalued shares with potential for long-term growth. Analysts review the P/E ratio to determine if the price per share accurately represents projected earnings per share. Often the EPS used in calculating the P/E ratio is P/E (TTM), where TTM is trailing 12 months or income of the company in the past twelve months.
What is a Good P/E Ratio?
Which is a good P/E ratio for one investor may not work for another. This is because investors have different ways to look at the P/E ratio depending on one’s investment objectives – whether it is oriented towards value or growth.
Value investors will always go with a low P/E ratio that tells them that company shares are undervalued compared to peers. Conversely, growth investors will consider companies with high P/E considering it represents higher possibilities of growth.
Growth investors calculate two P/E ratios, namely the forward-looking P/E ratio and the price-to-earning-to-growth ratio (PEG).
Investors use a simple formula to calculate the forward-looking P/E ratio. They substitute EPS from the trailing twelve months with EPS projected for the next financial year. Conversely, the PEG ratio measures a company’s growth in earnings per share, calculated by dividing a company’s P/E ratio by the rate of earnings growth. The most common is calculating the PEG ratio for five years, but one can adjust it for any duration, making it flexible for computing stock price.
Besides the P/E ratio, investors also use the Price/Sales ratio and Price/Book ratio for stock valuation.
Avoiding Value Trap
Value investors often run the risk of picking stocks that showcase low P/E ratio because of intrinsic business conditions – weak fundamentals and deteriorating business conditions. Investors need to avoid falling into a value trap and look into a company’s fundamentals when its P/E is suspiciously low.
Key Takeaways
- Stock valuation helps investors discover the true value of a stock.
- There are several methods for valuing stocks, each with its own set of advantages and disadvantages.
- There are two primary types of stock valuation – absolute and relative. The Absolute method uses a business’s fundamentals and financials to discover the stock’s actual value, and Relative methodology compares its position against peers and industry standards.
- While selecting a valuation model, make sure it is appropriate for the business.
- Often investors combine different valuation methods to conduct comparative valuation against competitors and broader markets for a holistic understanding.
The Concluding Note
Stock valuation is a critical measure of calculating fair value. It allows investors to perform a comparative study of stocks to learn, which can grow in the long run. However, there are more than one ways to view stock valuation and also to interpret it. Hence, investors must consider a company’s strengths and weaknesses while gauging its value. For example, companies with a clear competitive advantage have a better chance of survival against increasing competition, whereas companies with a large base benefit from network effects.
There are several ways to determine the value of stocks, and it may take investors some time to master the art.
