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 stock valuation process, which discovers stocks’ intrinsic value. To earn market-beating returns on your investment, you must master 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. Let’s discuss the types and methods of stock valuation and how we can base our decisions on stock valuations.
What Is Stock Valuation?
Stock valuation is the most crucial skill that investors must 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, 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
Stock valuation methods can be primarily categorized into two main types: Absolute and Relative.
1)Absolute–
The absolute method of stock valuation relies on the fundamental analysis of a business. It bases valuation on 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 the computation of the dividend discount model (DDM), discounted cash flow model (DCF), residual income model, and asset-based model.
As the name suggests, the absolute method doesn’t compare the company’s performance with peers.
2)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.
Common Stock Valuation Methods
Valuing stocks is a process that can be generally viewed as a combination of both art and science. Investors may be overwhelmed by the amount of available information that can be potentially used in valuing stocks.
Therefore, an investor needs to be able to filter the relevant information from unnecessary noise. Additionally, an investor should know about common stock valuation techniques and the scenarios in which such methods are applicable:
A)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 company’s dividends 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 payments 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 that removes the complications of variable dividend payout.
B)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 that don’t pay dividends.
There are several ways available to calculate DCF. However, the two-stage DCF model is the most popular, where investors first calculate the free cash flow forecast for five to ten years and then measure the terminal value for all the cash flows beyond the forecasted period.
Companies must have the stable and predictable free cash flow to efficiently calculate valuation based on the DCF model. Thus, mature companies past the growth stage are considered the ideal candidates for DCF valuation.
The Comparable Analysis
The comparable analysis compares 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 stock valuation methods anyone can apply.
Comparing the P/E ratio forms the cornerstone of stock valuation. The 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 price-to-earnings (P/E) ratio is one of the most widely used stock valuation metrics, and it is often used as a basis for stock valuation theory. The P/E ratio compares a company’s current stock price to its earnings per share (EPS), providing insight into how much investors are willing to pay for each dollar of earnings the company generates.
Generally, a higher P/E ratio indicates that investors are willing to pay more for each dollar of earnings. It can be interpreted as a signal of higher growth prospects or a premium for the company’s perceived quality. Conversely, a lower P/E ratio may indicate that investors are more skeptical about the company’s growth prospects or have concerns about its financial health or competitive position.
The P/E ratio is often used with other valuation metrics, such as earnings growth rates, dividend yields, and price-to-book (P/B) ratios, to comprehensively assess a company’s valuation. However, it is important to note that the P/E ratio alone is not a perfect measure of a company’s intrinsic value and should be used with other analyses and research.
Overall, while the P/E ratio is not the only metric used in stock valuation theory, it is a widely recognized metric that can provide insight into investor sentiment and market expectations for a particular company.
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