Why To Know How To Value A Stock?

If you are an investor and you want to beat the market, you must master the skill of stock valuation. To put it simply, it is a method to determine the theoretical value or intrinsic value of a stock. It is very important to value stocks because the current price of a stock does not attach to its intrinsic value. When you know the intrinsic value of a stock, you can determine if the stock is undervalued or overvalued according to its current market price. 

How do you value a company stock?

Stock valuation is a very complicated process. You can say that it is a combination of science and art. It is overwhelming to know the amount of available information investors can potentially use in valuing stocks. The information includes the financials of companies, economic reports, stock reports, newspapers, etc. This is why an investor must be able to filter important information from the unnecessary noise. Moreover, investors should also know about major stock valuation methods along with the scenarios in which they can apply those methods. 

Types Of Stock Valuation

You can categorize stock valuation methods into two types, such as –

Absolute Stock Valuation: 

This method relies on the fundamental information of the company. It usually involves the analysis of several pieces of financial information. You can find or derive them from the financial statements of the company. Many absolute stock valuation techniques investigate the company’s cash flows, growth rates, and dividends primarily. Major absolute stock valuation methods include the discounted cash flow model (DCF) and the dividend discount model (DDM). 

Relative Stock Valuation: 

This method concerns the comparison of the investment with similar companies. It deals with the calculation of the important financial ratios of similar companies and the source of the same ratio for the target company. The greatest example of this method is comparable companies’ analysis. 

Popular Methods Of Stock Valuation

Dividend Discount Model (DDM): 

The dividend discount model is a basic technique of absolute stock valuation. It is based on the assumption that the dividends of the company represent the cash flow of the company to its shareholders. To put it simply, the model states that the intrinsic value of the company’s stock price is equivalent to the current value of the company’s future dividends. Keep in mind that you can apply the dividend discount model only when the distribution of company dividends is regular and stable. 

Discounted Cash Flow Model (DCF): 

Another popular method of absolute stock valuation is the discounted cash flow model. Under this approach, you can calculate the intrinsic value of a stock by discounting the free cash flows of the company to its current value. The main benefit of this method is that you do not need to assume anything involving the dividend distribution. Therefore, it is suitable for companies with an unpredictable or unknown distribution of dividends. However, from a technical perspective, the DCF model is sophisticated. 

Comparable Companies Analysis: 

The comparable analysis is a type of relative stock valuation. In this method, one does not use the company’s fundamentals to determine the intrinsic value of a stock. Instead, this method aims to source a stock’s theoretical price by using the price multiples of similar companies. The multiples investors use most include the price-to-book (P/B), price-to-earnings (P/E), and enterprise value-to-EBITDA (EV/EBITDA). From a technical perspective, this method is one of the simplest methods. However, it is challenging to determine truly comparable companies.

DCF Analysis Vs Comparable Analysis: The Most Popular Valuation Methods

The DCF model refers to a set of approaches that you can also call “Present value models”. As mentioned before, the approaches assume that the value of an asset and the present value of the future monetary benefits are equal. It is easy to use if the future cash benefits are reasonably forecasted or known. Usually, the inputs a DCF model requires are the future cash flows, any growth rate of the cash flows, and the opportunity cost or the required rate of return, which you can use as a discount rate. 

Two of the most common variations of the DCF model are the free cash flow (FCF) and the dividend discount model (DDM). FCF has two forms as well, such as free cash flow to equity (FCFE), and free cash flow to firm (FCFF) models. In the DDM, future dividends stand for cash flows that are discounted with a related needed rate of return. If companies are likely to increase dividend payouts, this is also something to model. Moreover, single or multiple growth rates represent short-term and long-term growth rates which also add to the model. 

Advantages

  • You can justify the intrinsic value of equity.
  • Rather than accounting figures, it relies on free cash flows.
  • Different variations of the model stand for different growth rates.

Disadvantages

  • This method relies on assumptions on inputs.
  • It is difficult to predict cash flows in cyclical businesses. 

The comparable method, however, uses ratios from similar companies, peer group, or industry and estimate the equity value of a company. The ratios or multiples it uses are P/E, P/S, and EV/EBITDA. This is why people also call this method the “multiples method”. The concept behind this method is the law of one price which shows that similar assets should have a similar price. By rephrasing this for a company earning or profit, we can come to this conclusion that companies with similar revenues and earnings should have the same value. 

Advantages:

  • This method is easy to understand and apply
  • Unlike DCF, it uses fewer assumptions.
  • It captures the current mood of the market better

Disadvantages

  • The choice of multiples is subjective sometimes.
  • It is difficult to find comparable with identical or similar revenue drivers. 
  • It is assumed that the market values the peer group accurately. 

Which model you should use depends on specific factors like the accuracy and availability of inputs. It is different according to the type, maturity, and stability of the companies as well.