Understanding the Different Methods of Stock Valuation

Introduction

Stock valuation is the process of determining the current worth of a company's stock. This is important for investment decisions, such as deciding when to buy or sell the stock, and is done using various methods to assess a company's long-term financial health.

One of the key benefits of stock valuation is the ability to compare multiple stocks in the same pool or sector and to make reasoned investment decisions. There are several methods used to value stocks, each of which can be used to provide a deeper understanding of the company.

Reasons to value a company's stock

• To help make long-term financial decisions
• To help compare multiple stocks in the same pool
• To better understand a company's financial health
• To inform purchase and sale decisions

Overview of stock valuation methods

• Discounted Cashflow
• Price to Earnings Ratio
• Price to Sales Ratio
• Price to Book Ratio
• Dividend Discount Model

Discounted Cash Flow

Discounted cash flow (DCF) is one of the most common methods used to determine the intrinsic value of a company using its expected future cash flows, and is often used by stock market investors to make decisions on investments. This method helps to identify whether an investment is undervalued or overvalued by comparing the amount of money that can be expected to be generated by an investment in future cash flows to the amount of money that the investor has to pay to acquire said investment.

What is Discounted Cash Flow (DCF) and How Does It Work?

DCF is based on the notion that the value of an asset is the present value of its future expected cash flows. The present value of future cash flows is calculated by discounting them back to their present value at a rate that compensates for the time value of money and the investor’s calculated required rate of return. The discount rate used is generally unique to the asset being valued and is typically determined by both the nature of the asset and the investment’s riskiness.

How to Calculate the Required Rate of Return and Discount Factor

Calculating the required rate of return is done by establishing the range of potential returns an investment can yield, factoring in the associated risks involved. A rate of return that an investor deems acceptable is determined by the returns of similar investments and the investor’s tolerance for risk. The discount factor is then determined by taking the rate of return and subtracting it from a predetermined inflation rate. This discount factor is then used to calculate the present value of future cash flows.

Benefits and Limitations of Discounted Cash Flow

DCF is seen as one of the most reliable methods of stock valuation as it is based on metric establishements rather than subjective predictions. It helps investors to take into account the time value of their money and gives them an indication as to whether an investment is undervalued or overvalued.

However, there are some limitations to DCF. Since it is based on estimates, it could result in an inaccurate valuation if these underlying inputs are based on inaccurate estimates. Additionally, DCF is reliant on the investor to calculate an appropriate discount rate, which often has no definitive answer.

Price to Earnings Ratio

The Price to Earnings ratio, or P/E ratio, is a metric used to measure the value of a stock compared to the company’s underlying earnings. It’s one of the primary metrics that investors use to determine fair valuation of a given stock.

What is P/E and How Does it Work?

The P/E ratio is calculated by dividing the current market price of a given share to the company's most recent reported earnings per share (EPS). For example, if a stock is currently trading at $100 per share, and the company reported $3 of earnings per share over the trailing 12 months, then the company P/E ratio would be 33.33 ($100 / $3). Essentially, P/E is expressing how much investors believe they can reasonably expect to pay for each $1 of the company’s profits.

Key Components and Calculation

The key components of the P/E calculation are the current market price the stock and the company’s most recent reported earnings per share (EPS). Current market prices are easily determined and reported; however, reported EPS can differ largely depending on the different methodologies applied by each company. Understanding these differences and evaluating potential implications of reported EPS is critical for accurate P/E ratio analysis.

Benefits and Limitations of P/E

The P/E is a useful metric to compare stocks in the same industry and to evaluate past and predicted performance of the stock. Comparing the P/E ratios of stocks in the same industry can highlight the best possible investments and identify relative overvaluation or undervaluation in the industry. Further, investors can use the P/E ratio to consider the past performance of a stock and historically predict future changes in its price. However, there are limitations to the P/E ratio; for example, it does not consider additional factors such as dividend or capital appreciation.

• Benefits:
  • Useful to compare stocks in the same industry
  • Can be used to evaluate past and predicted performance of the stock
  
  
• Limitations:
  • Doesn't consider additional factors such as dividend or capital appreciation
  
  

Price to Book Ratio

Price to Book (P/B) Ratio is a financial metric which is used to compare a company’s market value to its book value. It mainly looks into a company’s financial strength within the context of its current share price. It is also referred to as a Market to Book (M/B) ratio.

What is P/B and how does it work?

Book value is an accounting measure which refers to the portion of a company that would be left over when the company liquidates all its assets and pays off all its liabilities. A company’s stock price, on the other hand, is the current market value of the company, determined by the demand for the shares in the stock market. The Price/Book ratio compares the market value of a company’s stock to its book value.

Key components and calculation

The P/B ratio is simply calculated by dividing a company’s stock price by the company’s book value. Generally, a lower P/B ratio indicates that the company might be a better value, while a higher P/B ratio indicates that the stock is overpriced.

• Stock Price = The current market price of the company’s stock
• Book Value = Assets - Liabilities

Benefits and Limitations of P/B

P/B ratio provides a better indication of value than the market capitalization. It is particularly useful for comparing companies in different industries that cannot be fairly compared using conventional methods. However, it does have certain limitations, such as it does not take into account the types of assets, which can be highly valuable to some companies and not valuable to others. It also does not take into account the quality of the company's management.

Enterprise Value Multiples

An enterprise value multiple (EV multiple) is a stock valuation metric that compares the enterprise value of a company to a financial metric, such as operating profit, to produce a single, easy-to-understand ‘multiple’ of the company’s financial performance. EV multiples are useful for comparing the relative value of different companies or of the same company at different points in time.

What are EV multiples and how do they work?

EV multiples work by comparing a company’s enterprise value, rather than its market capitalization, to a key accounting/operating metric. This metric can be either absolute (e.g. total sales) or relative to market size (e.g. sales per capita). EV multiples remove the influence of capital structure and make the comparison among companies more meaningful.

Popular EV multiples, key components and calculation

EV multiples are typically reported as ratios, although absolute multiples such as price/earnings are also popular. The most popular EV multiples are price/earnings (P/E), enterprise value/EBITDA (EV/EBITDA), enterprise value/sales (EV/Sales), price/book (P/B) and price/cash flow (P/CF). Each multiple is calculated by dividing the enterprise value of a company by the relevant financial metric (e.g. EBITDA, sales, etc.).

Benefits and limitations of EV multiples

EV multiples offer an easy way to compare companies and assess their relative value. By removing the influence of debt and other capital structure items, EV multiples are less complex and more reliable than other stock valuation methods. However, EV multiples do not capture the entire picture and should be used in conjunction with other stock valuation techniques. They are also not appropriate for companies with different capital structures or business models.

Comparable Analysis

Comparable analysis, otherwise known as the “multiple approach” or “relative value approach”, is a method of stock valuation that compares a stock’s valuation with that of similar companies in order to estimate the true value of a company. Comparable analysis involves comparing many stocks and finding common financial characteristics among companies. Through comparing various different stocks, through both financial and nonfinancial measures, one can estimate the approximate true value of a stock.

Peer Groups and Selection Criteria

Peer groups are groups of similar companies that are compared to assess the value of a company. When compiling peer groups, certain selection criteria must be taken into account; such as revenue size, market capitalization, sector, and industry. To be accurate and relevant, comparable companies should have a degree of similarity in the factors mentioned; this means this method of stock valuation is best suited to large, publicly traded companies.

Benefits and Limitations of Comparable Analysis

The benefits of comparable analysis is that it takes into account the relative strengths and weaknesses of different companies, while also factoring in how these companies are publicly traded and viewed among investors. Additionally, since it generally requires the use of an outside source, such as financial databases or newspapers, this method is more easily implemented for those with limited financial knowledge, or for those with limited data availability.

The main limitation of this method of stock valuation is that it is focused solely on short-term factors, and ignores long-term trends or the potential for growth. Additionally, it is difficult to account for the effects of company-specific factors, such as product development or marketing efforts. As such, it is important to consider other evaluation methods alongside comparable analysis.

Conclusion

When it comes to stockvaluation, there are various methods and key considerations that must be kept inmind. Let’s summarize the essential stock valuation methods and key considerations that may help when evaluating a company’s stock.

Summary of stock valuation methods

The four most widely-used stock valuation methods are the dividend discount model, free cash flow to firm model, price-to-earnings ratio, and residual income model. Briefly, the dividend discount model is based on future dividends and discounting them back to the present, the free cash flow to firm model indicates the stream of free cash flows from the operations belonging to shareholders, the price-to-earnings ratio is based on the stock’s price to its earnings and the residual income model quantifies the value of a company’s additional income.

Key considerations when valuing stock

• Growth prospects and competitive advantage
• Risk and volatility of the stock
• Gross margins, cost structure and asset utilization
• Overall macroeconomic and industry conditions
• Integrity, skill set, and culture of the management
• Political and regulatory environment
• Market liquidity

Outlook and importance of stock valuation

Expected company growth and future cash flows can be estimated through stock valuation method, which helps to determine the fair value of a stock. Although financial statements, analyst reports, and other documents often can provide a general idea of a company’s stock, stock valuation is essential in order to assess the real value of the equity. By utilizing the appropriate stock valuation method, along with considering the key stock valuation considerations, one may make educated and informed decisions when investing in stocks.