Author: Doumkou Stefani
Publication date: 17.07.2024
Stock valuation is fundamental to making sound investment decisions. However, if it was simple, we'd all be millionaires. The reality is that valuation is a complex process influenced by various factors, and different methods and techniques can yield different results depending on the market and sector in question.
In this article we will provide a comprehensive guide on stock valuation methods, focusing on both absolute and relative valuation techniques. We will explain key concepts, metrics, and steps involved in valuing a stock.
What is the value of a stock?
The value of the stock portrays the perception of the market toward a company's future earning potential and general financial health. It thereby affects investment decisions and reflects the company's worth and performance in the financial market. Determination of the value of a stock has various methods, but mainly they come under two broad categories: absolute valuation and relative valuation.
About Absolute Valuation
Focuses on stocks intrinsic value.
This method uses fundamental financial data, such as dividends, cash flows, and growth rates.
The most common models in current use are the Dividend Discount Model and Discounted Cash Flow.
Strength: Provides a detailed, intrinsic value estimate based on the company's actual financial performance and future expectations.
About Relative Valuation
Compares a stock’s value to that of similar companies.
It uses financial ratios such as the Price-to-Earnings ratio, Price-to-Book ratio, Price-to-Earnings Growth, etc.
Easier and quicker to apply. Often used for preliminary judgments.
Strength: Helps determine if a stock is undervalued or overvalued compared to its peers.
Steps to Value a Stock
Valuing a stop can involve various methods and approaches depending on the context. Here are some general steps and methods commonly used.
1. Gather Financial Data
Obtain the company’s financial statements, including income statement, balance sheet, and cash flow statement. Gather industry data and financial metrics of comparable companies.
2. Calculate Key Financial Ratios
No matter what method you use to valuate a stock or a company very important metrics to consider are and number to have in mind are the following:
Price-to-Earnings(P/E)Ratio=Market Price per Share/ Earnings per Share (EPS)
Price-to-Book (P/B) Ratio=Market Price per Share/ Book Value per Share
Price-to-Earnings Growth (PEG) Ratio=(P/E Ratio)/ Earnings Growth Rate
Dividend Yield: Annual Dividends per Share /Market Price per Share
3. Perform Absolute Valuation
Dividend Discount Model (DDM): This model involves valuing a stock by estimating the present value of all future dividends it is going to pay. If a company pays regular dividends, you project the payments and discount them back to today's value to find the worth of the stock.
Use DDM if: The company has a stable history of paying dividends and you expect it to continue doing so.
Discounted Cash Flow (DCF) Model: The DCF model values a company by estimating the present value of its future cash flows. For companies with significant cash flows, you predict these cash flows over time and discount them back to today's value to determine the company's worth.
Use DCF if: The company generates substantial cash flows, and you can reasonably forecast these cash flows into the future.
4. Perform Relative Valuation
Compare the calculated financial ratios (P/E, P/S, P/B, etc) to those of similar companies in the same industry. Then determine if the stock is undervalued or overvalued relative to its peers. It is a straightforward and practical method for evaluating investment opportunities. For example, If the stock’s P/E and P/B ratios are lower than the industry average, indicating potential undervaluation. If the intrinsic value from the DCF model is close to the current market price, suggesting fair value.
5. Analyse the Results
Combine insights from both absolute and/or relative valuation. Consider the company’s growth potential, financial health, industry position, and economic conditions etc.
6. Make an Investment Decision
Use the combined valuation results to decide whether to buy, hold, or sell the stock. Next ensure your decision aligns with your investment strategy and risk tolerance.
Quantitative Analysis Valuation
Beyond mere numbers, qualitative factors provide valuable insights into a company's potential. This type of analysis considers non-numerical elements that might influence a company's intrinsic value. This includes assessing management quality, such as the historical performance and competence of the leadership team. It also considers the company's strategic advantages like brand strength, patents, and market share, as well as industry trends and broader economic factors impacting future performance.
Conclusion
When valuing a stock, it's important to use multiple methods for a complete picture. No single valuation model fits every situation. Only by knowing the characteristics of the company can one select a model that best fits the situation. Absolute and relative valuation methods project valuations of a stock based on the financial health and performance. Technical, like candlestick charts, on the other hand, show the price movements by using past information. Just keep in mind that each approach serves different purposes, catering to distinct types of investors and traders.
If you want to learn more about Stocks check MarketXLS
You can also read about:
Comentários