Every investor who is eager to beat the market must be expert at the skill of stock valuation. Essentially, stock valuation is an approach of ascertaining the intrinsic value (or theoretical value) of a stock. The significance of valuing stocks evolves from the fact that the inherent value of a stock is not connected to its ongoing price. By understanding a stock’s intrinsic value, an investor might determine whether the store is over- or under-valued at its current market price.
Why are stocks important in businesses?
Stock valuation is a crucial tool that can assist investors in making informed judgements about commerce. It is a method that shapes the value of a company’s stock by utilizing standard directions. It values the fair market value of a financial tool at a particular time. The main reason for stock valuation is to predict the future price or possible market prices for the investors to manage their purchase of investments and sales.
The stock valuation fundamentals assist in valuing the “Intrinsic” value of the stock that demonstrates the benefit of the business and its future market value. Investors often erroneously consider that a great company goes into a significant investment.
Finding strong companies is necessary for the investment process, but it is equally important to determine what those companies’ stocks are worth. Your aim as an investor might be to find beautiful businesses and invest in them at exceptional prices. If you deny confusing a great company with a significant investment, you will already be ahead of the considerable number of your investing partners.
Consider you are purchasing a car. Before you make a purchase, you will be willing to do some research, determine a few good candidates, and take each for a test drive. But throughout the process, you will also be aware of the price. After all, you would not pay $50,000 for a used clunker, though you might pay that much for a new luxury car. Likewise, you might never spend $200,000 on a car, no matter the make.
The same thing should be right if you are thinking about buying a stock. How to Value a Stock?
Valuing stocks is a too confusing process that can be viewed as a combination of both science and art. Investors can be devastated by the amount of available data that can be potentially utilized in valuing stocks (company’s financials, newspapers, economic reports, etc.).
Therefore, an investor should be able to filter the relevant information from the unnecessary noise. To add that, an investor needs to know about primary stock valuation methods and the scenarios in which such practices are suitable.
Types of Stock Valuation
Stock valuation approaches can be primarily categorized into two main types: absolute and relative.
Absolute stock valuation relies on the company’s necessary data. The method contains the analysis of different economic information that can be found out or emerged from a company’s financial statements. Many ways of absolute stock valuation primarily investigate the company’s cash flows, dividends, and growth rates. Notable fundamental stock valuation methods include the dividend discount model (DDM) and the discounted cash flow model (DCF).
Relative stock valuation deals with the comparison of the investment with similar companies. The comparative stock valuation method deals with the calculation of the key financial ratios of similar companies and derivation of the same rate for the aimed company. The best case of relative stock valuation can be differentiated with business analysis.
Popular Stock Valuation Methods
In the following, we will shortly discuss the most well-known approaches of stock valuations.
1.Dividend Discount Model (DDM)
The dividend discount approach is one of the standard methods of absolute stock valuation. The DDM is depended on the assumption that the company’s dividends present the company’s cash flow to its shareholders. Essentially, the model indicates that the intrinsic value of the company’s stock price equals the present value of the company’s future dividends. Note that the dividend discount model is acceptable only if a company distributes dividends regularly, and the distribution is steady.
2.Discounted Cash Flow Model (DCF)
The discounted cash flow model is another famous approach to absolute stock valuation. Under the DCF technique, the intrinsic value of a stock is evaluated by discounting the company’s free cash flows to its current price. The most significant advantage of the DCF model is that it does not demand any assumptions regarding the distribution of dividends. Thus, it is applicable for companies with unpredictable dividend allocation. Yet, the DCF model is experienced from a technical look.
3.Comparable Companies Analysis
The comparable analysis is a model of relative stock valuation. Instead of finding out the intrinsic value of a stock using the company’s fundamentals, the comparative method assists in deriving a stock’s theoretical price by utilizing the valuation multiples of companies alike.
The most commonly used multiples contain the price-to-earnings (P/E), price-to-book (P/B), and enterprise value-to-EBITDA (EV/EBITDA). The comparable companies analysis approach is one of the easiest from a technical perspective. However, the most challenging part is the determination of truly similar companies.
Methods used under Relative Valuation:
Relative Valuation technique uses ratio and other types of valuation methods to ascertain the value of the stock. The rate is the most commonly used method as it is easy to calculate and is available at hand. The standard ratios utilized are:
- Price for per earning
- Earnings per share
- Price-earnings-to-growth ratio
- Sum of Perpetuities approach
- Return on assets
- Enterprise value
- Market capitalization
- Enterprise value-to-sales ratio
These ratios assist the traders and the investors in estimating the fair value of stock and making planned decisions when transacting in the stock market.
If you intend to invest in the stock market, you can make use of ratios and approach to determine the value of a stock. However, valuation methods are not the only technique to conduct trade, and you should think about other parameters such as the history of the company and its trend before trading. It is also prudent to work valuations of different ratios and find the average of them to obtain an exact market value of the stock.