Stock valuation is the process of estimating the intrinsic value of a company’s shares and comparing it with the current market price. The intrinsic value is the true worth of a company, based on its future earnings potential, assets, and growth prospects. The market price is the price at which the shares are traded in the stock market, influenced by supply and demand, investor sentiment, and market conditions.
Stock valuations are important because they can help investors identify undervalued or overvalued stocks and make informed investment decisions. Undervalued stocks are those that trade below their intrinsic value, indicating that the market is underestimating their potential. Overvalued stocks are those that trade above their intrinsic value, suggesting that the market is overestimating their performance. By valuing stocks, investors can determine the fair price of a stock and decide whether to buy, sell, or hold it.
There are two main ways to get stock valuations: absolute and relative. Absolute valuation methods focus on the fundamentals of the company and estimate its intrinsic value based on its expected future cash flows, dividends, or earnings. Relative valuation methods compare the company’s valuation ratios with those of similar companies or the industry average and assess its relative value based on its peers or the market.
Absolute Valuation Methods
Some of the common absolute valuation methods are:
Discounted Cash Flow (DCF) Model
This method projects the company’s future free cash flows (FCF), which are the cash flows that the company generates after deducting its capital expenditures, and discounts them to the present value using an appropriate discount rate, which reflects the risk and opportunity cost of investing in the company. The sum of the present values of the future FCFs is the intrinsic value of the company. The DCF model is widely used by analysts and investors, as it captures the company’s ability to generate cash and grow over time. However, it also relies heavily on the assumptions and estimates of the future cash flows and the discount rate, which can introduce errors and uncertainties in the valuation.
Dividend Discount Model (DDM)
This method values the company based on its expected future dividends, which are the payments that the company distributes to its shareholders from its earnings. The DDM assumes that the intrinsic value of the company is equal to the present value of its future dividends, discounted by the required rate of return, which is the minimum return that investors expect from investing in the company. The DDM is suitable for valuing stable and mature companies that pay regular and consistent dividends. However, it is not applicable for valuing young and growing companies that reinvest their earnings instead of paying dividends, or companies that have erratic dividend policies.
Residual Income Model (RIM)
This method values the company based on its expected future residual income, which is the income that the company earns above its cost of capital. The RIM assumes that the intrinsic value of the company is equal to the sum of its book value (the value of its assets minus its liabilities) and the present value of its future residual income, discounted by the cost of equity, which is the cost of financing the company with equity. The RIM is useful for valuing companies that have positive and sustainable residual income, as it reflects the company’s ability to create value for its shareholders. However, it also depends on the accuracy and reliability of the accounting information and the assumptions and forecasts of the future residual income.
Relative Valuation Methods
Some of the common relative valuation methods are:
Price-to-Earnings (P/E) Ratio
This method compares the company’s stock price with its earnings per share (EPS), which is the portion of the company’s earnings that is attributable to each share. The P/E ratio measures how much the market is willing to pay for each dollar of the company’s earnings, indicating the company’s growth expectations and profitability. A higher P/E ratio implies that the market has high expectations for the company’s future growth and performance, while a lower P/E ratio suggests that the market has low expectations or concerns about the company’s prospects. The P/E ratio is a popular and simple metric for valuing stocks, as it can be easily calculated and compared across companies and industries. However, it can also be affected by various factors, such as accounting policies, earnings volatility, and business cycles, which can distort the valuation.
Price-to-Sales (P/S) Ratio
This method compares the company’s stock price with its sales per share, which is the portion of the company’s revenue that is attributable to each share. The P/S ratio measures how much the market is willing to pay for each dollar of the company’s sales, indicating the company’s efficiency and market position. A lower P/S ratio implies that the company is undervalued or has a competitive advantage, while a higher P/S ratio suggests that the company is overvalued or has a weak market position. The P/S ratio is useful for valuing companies that have low or negative earnings, as it focuses on the top line of the income statement. However, it can also ignore the cost structure and profitability of the company, which can affect the valuation.
Price-to-Earnings Growth (PEG) Ratio
This method adjusts the P/E ratio by the company’s expected earnings growth rate, which is the annual percentage change in the company’s earnings. The PEG ratio measures the trade-off between the company’s stock price, earnings, and growth, indicating the company’s value relative to its growth potential. A lower PEG ratio implies that the company is undervalued or has a high growth potential, while a higher PEG ratio suggests that the company is overvalued or has a low growth potential. The PEG ratio is a refined and dynamic metric for valuing stocks, as it incorporates both the current and future performance of the company. However, it can also be influenced by the accuracy and variability of the earnings growth estimates, which can vary widely among analysts and sources.
Conclusion
Stock valuations can be complex and hard to get. There is no single or definitive way to value a stock, as different methods can yield different results and interpretations. Therefore, investors should use multiple methods and sources of information, as well as their own analysis and due diligence, to arrive at a reasonable and robust valuation. By understanding and applying different methods to get stock valuations, investors can gain insights into the company’s fundamentals, growth prospects, and market position, and make better and smarter investment decisions.
