Finance

A Beginners Guide To Stock Valuation

A Beginners Guide To Stock Valuation

Essentially, stock valuation is a method of measuring the intrinsic value (or theoretical value) of a stock. The importance of valuing stocks evolves from the fact that the intrinsic value of a stock is not attached to its current price. When you buy some of the best undervalued stocks of strong companies this may be the case. So as an investor you need to find relevant information to help make your decision and you also need to know some stock valuation methods which we have listed below: 

How To Conduct A Stock Valuation

How to Value a Stock?

Stock valuation is an extremely complicated 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 (company’s financials, newspapers, economic reports, stock reports, etc.). Therefore, an investor needs to be able to filter the relevant information from the unnecessary noise. Moreover, all investors have to learn about the different types of stock valuation methods, learn about the pros and cons and gauge the application of these methods, depending on the situation. 

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Types of Stock Valuation 

Stock valuation methods can be primarily categorized into two main types: relative and absolute: 

Relative

This type of stock valuation relies on the comparison of the investment with similar companies. This type involves the calculation of the key financial ratios of similar companies and derivation of the same ratio for the target company. The best example of this type of stock valuation is comparable companies analysis.

Absolute

Absolute stock valuation is a type that generally involves the analysis of various financial information that can be found in or derived from a company’s financial statements. So it’s kind of easy to see that the primary information investigated is a company’s cash flows, dividends, and growth rates. The absolute stock valuation methods include the dividend discount model (DDM) and the discounted cash flow model (DCF).

Popular Stock Valuation Methods

Here is a guide on the most popular methods of stock valuation. 

1. Dividend Discount Model (DDM)

DDM is one of the basic techniques of absolute stock valuation. The DDM is based on the assumption that the company’s dividends represent the company’s cash flow to its shareholders.

Dividends are a good way to figure out a company’s value for your portfolio. When you’re looking at dividends, you’re getting an idea of how much fixed income your stock pick will give you regardless of market slumps. 

Essentially, the model states that the intrinsic value of the company’s stock price equals the present value of the company’s future dividends. DDM is applicable only if a company distributes dividends regularly and the distribution is stable. 

Learning to value stocks is about long term investing and about the company’s direct value. For those of you who want a safe bottom line, this is a good way to value stocks. 

2. Discounted Cash Flow Model (DCF)

DFC is another popular method of absolute stock valuation. Under the DCF approach, the intrinsic value of a stock is calculated by discounting the company’s free cash flows to its present value.

The main advantage of the DCF model is that it does not require any assumptions regarding the distribution of dividends, so it’s meant for companies with unknown or unpredictable dividend distribution. However, the DCF model is sophisticated from a technical perspective.

3. Comparable Companies Analysis

This method is an example of relative stock valuation. Instead of determining the intrinsic value of a stock using the company’s fundamentals. This method also aims to derive a stock’s theoretical price using the price multiples of similar companies.

The most commonly used multiples include the price-to-earnings (P/E), price-to-book (P/B), and enterprise value-to-EBITDA (EV/EBITDA). The comparable companies analysis method is one of the simplest from a technical perspective. However, the most challenging part is the determination of truly comparable companies.

P/E Ratio:

The ratio of price of the share to the amount that the company earned with investors’ money can say volumes about the company’s health. Ideally, you will find companies that have a lower P/E ratio than others in their industry. 

A low P/E ratio is an amazing thing for investors. This suggests that the price is not speculated, and that the company is using their money well. Here are some things to keep in mind:

  • Different industries will have different P/E ratios. A typical shoe making factory may only have a P/E ratio of around 8. Tech companies, on the other hand, may hover around 20 simply because it takes money to add money in the tech industry.
  • A high P/E doesn’t necessarily mean it’s a bad buy. It could suggest that they are still developing the product. 
  • There’s no perfect number for P/E ratios. Different investors look at different factors. 
  • P/E ratios can only tell so much. There’s a chance you could be seeing a value trap in the making. Use your common sense, and you’ll find it guiding you well. 

P/B Ratio:

If you are very deeply concerned about the way things are going in the economy, the P/B ratio will help you figure out the crux of the matter. The P/B ratio offers the current closing price of a stock share, and divides it by last quarter’s “book price.” 

The book price is the worth of the entire company’s assets, including property and patents. As you look at the P/B Ratio, you can learn if a company’s extrinsic value is undervalued compared to their legit, intrinsic value. To put it in other words, the P/B ratio is a bargain spotter.

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