Stock Valuation: Overview, & Effective Valuation Methods

Stock valuation is vital for any investor who aspires to gain more from the market. It is in essence, a way of evaluating a stock’s intrinsic worth (or theoretical worth). The importance of stock valuations stems from the fact that a stock’s intrinsic worth is unrelated to its current price. An investor can assess if a stock is over-or under-valued at its present market price by knowing its intrinsic value. Let’s see the most popular stock valuation methods/types and when to utilize them in this article.

What Is a stock?

A stock is a single share of a firm that indicates a small portion of the company’s ownership. As a stockholder, you can calculate your percentage ownership of the company by dividing the number of shares you own by the total number of shares outstanding and multiplying the result by 100. In most cases, owning stock in firm grants the stock owner both corporate voting rights and dividend income.

What Is the best way to value a stock?

Stock valuations are a complex process that may be a mix of art and science. The amount of available information that might possibly be employed in evaluating stocks may overwhelm investors. As a result, an investor must be able to separate the useful information from irrelevant noise. Furthermore, an investor should be aware of the most common stock valuations methods. As well as the contexts in which they are used

Methods of Stock Valuation

It’s easy to become overwhelmed by the number of valuation methods available to investors when determining the types to employ to evaluate a stock for the first time. There are some basic valuation procedures, while others are more detailed and complicated.

Unfortunately, there isn’t a single solution that works in every case. Each company is unique, and each industry or sector has its own set of features, necessitating the use of several valuation methods. There are a number of approaches to valuing a company or its stock. Each with its own set of advantages and disadvantages.

Types of Stock Valuation

Relative and absolute stock valuation methods are the two basic types of stock valuation procedures.

Absolute monetary value

Absolute valuation models seek to determine an investment’s intrinsic or “real” worth based solely on its fundamentals. Looking at fundamentals simply means concentrating solely on a single company’s dividends, cash flow, and growth rate, with no regard for other companies. The dividend discount model, discounted cash flow model, residual income model, and asset-based model are examples of valuation models that fall under this category.

Relative Valuation

Relative valuation models, on the other hand, work by comparing the company in issue to other companies that are similar to it. Calculating multiples and ratios, such as the price-to-earnings (P/E) ratio, and comparing them to similar companies’ multiples are part of these strategies. For instance, if a company’s P/E is lower than a comparable company’s P/E, the original company may be considered cheap. Many investors and analysts start their analysis with the relative valuation model since it is one of the types of stock that is typically easier and faster to calculate than the absolute valuation model.

Stock Valuation Popular Methods

Let’s look at some of the most popular stock valuation methods available to investors and see when each one is acceptable.

Discounted Dividends Model (DDM)

One of the most fundamental absolute valuation techniques is the dividend discount model (DDM). The dividend discount model determines a company’s “true” worth based on the dividends it pays to its shareholders. The reason for using dividends to assess a firm is that dividends represent actual cash flows to shareholders. Thus pricing the present value of these cash flows should give you an estimate of how much the shares should be worth.

The first step is to figure out whether or not the company pays a dividend.

Because it’s not enough for a corporation to simply pay a dividend, the second step is to examine whether the payout is steady and predictable. Mature blue-chip businesses in well-developed industries are more likely to offer consistent and predictable dividends. The DDM valuation methodology is often the greatest fit for these types of businesses.

The Gordon Growth Model (GGM) is a widely used method for calculating a stock’s intrinsic value based on a sequence of future dividends that grow at a constant pace. It’s a popular and easy-to-understand dividend discount method (DDM).

Discounted Cash Flow Model (DCF)

What if the corporation doesn’t pay a dividend or has an inconsistent payout pattern? Continue on to see if the company meets the criteria for using the discounted cash flow (DCF) model in this scenario. Instead of focusing on dividends, the DCF model values a company based on its discounted future cash flows. This method has the advantage of being applicable to a wide range of companies that do not pay dividends, as well as those that do pay dividends.

The DCF model comes in a variety of forms, but the Two-Stage DCF model is the most prevalent. Free cash flows are anticipated for five to ten years in this version, and then a terminal value is generated to account for all cash flows beyond the forecasted period. The company must first have positive and predictable free cash flows in order to use this approach. Due to the huge capital expenditures that these companies often face. Many small high-growth and non-mature enterprises will be disqualified based on this condition alone.

The target company should have steady, positive, and predictable free cash flows in order to employ the DCF model efficiently. Companies with appropriate cash flows for the DCF model are usually mature businesses that have passed their growth periods.

The Comparables Model

The last model is a catch-all model that can be utilized if none of the other models can be used to value the company or if you simply don’t want to spend the time crunching the figures. Unlike the previous two popular stock valuation methods, this one does not attempt to determine the stock’s intrinsic worth. Instead, it compares the stock’s price multiples to a benchmark in order to assess if it is cheap or overvalued. The logic behind this is the Law of One Price, which stipulates that two similar assets should sell for the same price. One of the reasons for this model’s popularity is its intuitive character.

Because there are so many different multiples to choose from, such as price-to-earnings (P/E), price-to-book (P/B), price-to-sales (P/S), price-to-cash flow (P/CF), and so on, the comparables approach can be employed in practically any situation. The P/E ratio is the most often utilized of these ratios since it focuses on the company’s earnings, which is one of the key determinants of an investment’s value.

Conclusion

Aside from quantitative measurements like the P/E ratio, investors should examine a company’s qualitative qualities and flaws when determining a stock’s worth. Make sure the valuation method you choose is acceptable for the firm you’re looking at, and if more than one is, combine them to get a better assessment. Companies with a relative cost advantage are more likely to be profitable. As well as those in areas with high switching costs can keep clients more readily. Patents, rules, and brand awareness are all examples of intangible assets that high-quality organizations have.

Frequently Asked Questions

Related Articles

1. Dividend Yield Formula: Meaning, Detailed Examples & Free Investor Tips
2. FAIR VALUE ACCOUNTING: Definition & Benefits of Fair Value Accounting
3. Business Valuation: All you need to know [Detailed Guide]
4. Price To Earnings Ratio (P/E Ratio) Formula & Usage
5. COMPANY VALUATIONS: Methods, Definition, and Importance of Valuations