Stocks would probably be terrible lovers.
They’re irrational, stress-inducing, and despite them telling everyone else about the “efficient-market hypothesis,” we all know that things aren’t always what they seem.
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So how does the average retail investor find true love in this age of zero-commission trading and short squeezes? How do we know it’s more than just another pump and dump?
Investors like Warren Buffet would suggest investing in value stocks—they have solid fundamentals and enough room for steady, sustainable, and long-term growth. To find these stocks, professional investors use sophisticated valuation methods to find the intrinsic value of the stock instead of its current market value.
This article looks at some basic stock valuation methods, the logic behind them, and how to use them to make better-informed investing decisions.
Sound good? Let’s dive in!
What Makes a Stock Valuable?
Stocks are inherently valuable because they are a share of a public company’s ownership, along with being an equity claim on the company’s cash flows.
Essentially, you own the right to receive a tiny fraction of the company’s profits when you buy a single share. If the business has a proven track record of success and is likely to exceed earning expectations tomorrow, it adds intrinsic value to that tiny share.
Furthermore, stocks are publicly traded on exchanges to get a very reliable estimate of the stock’s current market valuation. However, there is a difference between the market value of a company and its inherent or intrinsic value.
Share Prices and Stock Valuation
Share prices, and market valuation, are usually not a good indicator of the stock’s intrinsic value. Thus, when determining if a stock is overvalued or undervalued, prices are actually not very relevant at all. Further, stock prices can be affected by innumerable factors, even events like stock splits.
For example, Apple (AAPL) has been trading at around $147 per share for October 2021. To calculate the approximate market value of the company, we can simply multiply the price per share by the number of issued shares (2.46 trillion dollars, in case you were wondering).
When the company went public in December 1980, its shares were trading at $20 per share. Yet $22 invested in AAPL in 1980 would have been worth $15,200 in 2019, according to market data.
When we look at just the stock price, the two facts seem incompatible. For example, if the price of one share was $20 in 1980 and $147 in 2021, the investment value should be $147, not $15,200 in 2021.
In this case, the number of outstanding shares increased as the company gained value (using a process known as a stock split). Thus, all things kept equal, if the number of shares (supply) increases, the price (demand) will naturally decrease for each share.
So if you had 1 AAPL share in 1980 worth $22, it would have been split into many that are each worth $147 today.
It was borderline impossible to accurately value AAPL’s worth in 1980 when it was listed for $20 per share. It was a brand new company that could have failed just like any other business. A retail investor in 1980 could have decided to buy “cheap” stocks instead that they felt were undervalued compared to Apple. In fact, many early investors actually sold their positions on the IPO day.
It’s All About the Fundamentals
The example illustrates that stock valuation is a bit more complex than just looking at charts and stock prices. Instead, to estimate the intrinsic value of a stock, we need to look at the company’s fundamentals with the help of stock valuation methods.
Fortunately, they just sound more intimidating than they actually are.
Methods of Stock Valuation
In many ways, stock valuation is more art than science, and valuation methods are basically the brushes you’ll use to paint your masterpiece.
For someone new to the subject, the sheer number of stock valuation methods available can seem actually daunting at first.
To make things more complicated, no one method can be universally applied for all stocks. For example, using a discount model is preferable for dividend-paying stocks but might not be the right option for stocks that do not pay dividends. Thus, using the correct valuation method is extremely important when researching stocks.
There are mainly two broad categories that stock valuation methods can be classified into:
These methods rely on the company’s fundamental information like cash flows and dividend payments, publicly available on its financial statements. Examples of absolute methods include the discounted cash flow model (DCF) and the dividend discount model (DDM).
Relative methods compare the fundamental information between competing companies. By measuring the deviation from the norm, we can have an educated guess of whether the stock is undervalued or overvalued. A simple example of a relative method is comparable company analysis.
Now that we have a basic idea of what stock valuation methods are, what they are used for, and the two major categories, let’s look at some of the most popular stock valuation methods and how they work practically.
Dividend Discount Model (DDM)
The dividend discount model is a quantitative method used for predicting the price of a company’s stock. The model is based on the theory that its present-day price is worth the sum of all of its future dividend payments when discounted back to its present value.
A stock’s intrinsic value can be determined by the sum of all its future dividend payments discounted to their present value.
To realize the gains from a stock, an investor has to sell their shares. Otherwise, they could still generate income from the stock by receiving dividends. However, if they do not plan to sell their stock and realize their gains, the only actual revenue generated by the asset would be the dividend payment.
Thus, the dividend payments generated by a share for a period of time is its inherent fair value. This method uses the present value of all future dividend payments because the value of money decreases with time due to inflation (time value of money).
The dividend discount model is not particularly useful for stocks that do not pay dividends or if the growth rate is too high.
Company A is a stable, blue-chip company with a long history of dividend payments and a steady rate of annual dividend growth at 3%. The company’s cost of equity is 7% and the next year’s dividend is estimated to be $1.69 per share. Currently, the stock is trading at $81. Is it undervalued or overvalued?
Since we have all the information at hand, we can simply plug them into the model: (1.69 / (0.07 – 0.03)) = $84.5. According to the model, the inherent value of the stock ($84.5) is higher than the market value which makes the stock undervalued based on current prices.
Discounted Cash Flow Model (DCF)
DCF is a financial modeling tool used to value a business. Simply put the DCF is a forecast of a company’s free cash flow discounted back to today’s value.
A stock’s intrinsic value is equal to the present value of its future free cash flows.
Companies raise capital and generate income. However, since the money is borrowed, it carries a cost for the company as interest. Therefore, for a company to be profitable, it has to generate a higher rate of return on the capital through operations than the rate of interest it has to pay on that capital.
When we discount future free cash flows for a company, we’re essentially calculating their performance against a benchmark (which is the cost of capital in this case).
For example, a company takes a 10-year loan with 5% interest to fund its operations. Over the next 10 years, it has to generate enough income to cover the interest payments to break even. So its return on the capital should be at least more than 5% for it to be profitable. We find their present value by discounting the cash flows (how much they are worth today).
Once we have the present value of the future free cash flows of the company, we can find a fair valuation of the business with the help of additional information like the total cash and debt held by the company.
Not very useful for large companies with astronomical cash flows and easy access to capital with low cost.
DCF calculations can be fairly simple or extremely complex, depending on how they are modeled. Here’s a quick step-by-step process of using the DCF model on a stock:
1. Find the company’s average free cash flow (FCF) over the last three years.
2. Estimate the future free cash flows for the company.
3. Estimate the cost of capital for the company.
4. Use the following formula to arrive at the sum of total future cash flows discounted by the cost of capital:
Where CF is the free cash flow for the year and r is the cost of capital.
5. Add the total cash in the company’s books to the DCF and subtract the debt to arrive at the fair valuation of the company.
6. Divide the valuation by the number of outstanding shares to arrive at a fair value per share.
Let’s say Company A has $20,000,000 in cash and $8,500,000 in debt on its books. Over the next three years, the sales estimates are $1,200,000, $1,350,000, and $1,420,000. The cost of capital is 7% and the number of outstanding shares is 200,000 and the price per share is $70.
Since we already know the information required, we can just plug the numbers into the formula. Doing so, we find the DCF to be 3,459,780.59. If we add the cash and subject the debt, we get a total valuation of 14,959,780. If we divide that valuation by the number of outstanding shares, we get a fair value of $74.79 per share.
So we can ascertain confidently (at least, somewhat), that the stock is currently undervalued by the market.
Investors use many methods to value assets. Learn how mark to market is used.
Comparative Companies Analysis Explained
Comparative Companies Analysis, also known as Comps, is a relative valuation technique used to value a company by comparing that company’s valuation multiples to those of its peers.
By comparing the key fundamental metrics of similar companies, we can find their relative value against each other.
Some key metrics tell us a lot about a company’s financial health and its value. Suppose we group several companies that operate in a similar industry or share similar characteristics. In that case, we can use these metrics to match them up against each other and judge their relative value.
It can be really hard to find companies that are truly comparable. Since this method is a relative valuation method, getting the comparison group right is vital.
A comparative companies analysis usually looks at the following metrics of the companies:
- ☑️ Price-to-Earnings (P/E) Ratio
- ☑️ Price-to-Book (P/B) Ratio
- ☑️ Price-to-Earnings Growth (PEG) Ratio
- ☑️ Dividend Yield
Price-to-Earnings and Price-to-Book ratios help us understand the market valuation of the stock against the company’s actual earnings. The PEG Ratio and Dividend Yield help us get a clearer picture of the company’s historical growth and momentum.
Together, these four metrics can be considered as the four fundamental factors of stock value, and we explore them further in-depth in the next section below.
Here’s a quick comparable companies analysis for the three large-cap tech stocks—Amazon, Apple, Google (Alphabet).
There are many ways to interpret these ratios which is usually the next step. For example, we can clearly see that the P/E ratio for Amazon is much higher than the P/E ratio for the other two. While it could seem overvalued because of the high P/E, we also need to consider that it has a strong PEG ratio and the highest dividend yield.
Unlike absolute methods, it can be argued that comparative companies analysis leans much more towards art than science. In general, the strength of a comparative analysis will be highly influenced by the competency of the analyst too.
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The 4 Fundamental Factors of Stock Value
All public companies are statutorily required to publicly disclose their financial statements, which contain vital information about the business which can be used for stock valuation. To simplify financial statements, analysts often use financial ratios to ascertain the relative value of the stock.
Unfortunately, there is no magic formula, and there are countless ratios and metrics that can be used for stock valuation based on the circumstances. However, some ratios are extremely popular and generally accepted as the most important ones. In this section, we take a deeper look at them and how they work.
Price-to-Earnings (P/E) Ratio
Earlier in this article, we noted that share prices are not really relevant for stock valuation. However, we can learn a lot about a stock by finding out the relation between the company’s earnings and the market price, and the price-to-earnings (P/E) ratio works on the same idea.
P/E Ratio = Market value per share / Earnings per share (EPS)
Finding the current market value per share is simply the process of checking the stock’s ticker on your favorite stockbroker. The earnings per share (EPS) metric can also be found for each stock on most brokers’ stock information pages.
There are usually two major types of EPS – TTM (trailing twelve months), which is the EPS over the past 12 months (trailing P/E), and the company’s forecasted EPS for the future (forward P/E).
The price-to-earnings ratio is widely used in stock valuation as it reveals the premium an investor is willing to pay on the company’s current earnings. For example, if a stock has a P/E of 10x, investors are willing to pay $10 for $1 of current earnings.
If the P/E ratio is too high, it could indicate that the stock is overvalued by the investors as the earnings might not be able to sustain the valuation. Conversely, if the P/E ratio is too low, it could mean that the stock could be undervalued relative to its earnings.
The P/E ratio also helps us compare and benchmark stocks. All things equal, the difference in the P/E ratio between two stocks can make a difference in how they are valued inherently.
Like all other metrics, it is not wise to use the P/E ratio in isolation. It should ideally be used with the different ratios to get an accurate valuation. In some cases, when a company doesn’t declare earnings or declares losses, the P/E ratio cannot be determined.
Fun fact: P/E ratio can never be negative for a company. In the event that a company has no profits or losses, the P/E ratio is “N/A.”
Price-To-Book (P/B) Ratio
The price-to-book (P/B) ratio measures the relationship between the market value of a company and its book value (tangible net assets). Unlike the price-to-earnings ratio, it is possible to ascertain the P/B ratio for loss-making companies.
P/B Ratio = Market value per share / Book value per share
The company’s book value is essentially the value that can be extracted by shutting down the company. For example, a company may own new heavy equipment while also making extremely heavy losses. If the company has to wind up, it can still sell the assets and generate some money that can be paid back to the investors.
P/B ratio, used along with other metrics like return-on-equity (ROE), can be beneficial when it comes to stock valuations. In general, a healthy growth stock should show an increase in the P/B ratio in response to a rising ROE.
However, there are several limitations with the P/B ratio too. For public companies, it can be hard to estimate a general benchmark for the P/B ratio, as it can vary from one industry to another. Therefore, it is recommended to use the P/B ratio in conjunction with other metrics and valuation methods.
Price-to-Earnings Growth (PEG) Ratio
Another metric used in stock valuation is the price-to-earnings growth (PEG) ratio. To put it simply, this ratio is derived by dividing the P/E ratio by the expected growth rate of the company’s earnings. It is used alongside the P/E ratio to get a better understanding of a stock’s value.
Here’s an example—Stock A is trading at $50, and it has an EPS of $2.40 and $1.80 over the last two years. Stock B is trading at $56, and it has an EPS of $2.80 and $1.90 in the previous two years. So which one of them is relatively overvalued?
Stock B is relatively undervalued; the difference becomes more pronounced when using the PEG ratio instead of the P/E Ratio. So essentially, we can adjust the P/E Ratio with our projected growth using the PEG ratio.
Ideally, the PEG ratio should be under 1x for a stock to be considered undervalued. But conversely, suppose the PEG ratio is above 1x. In that case, there’s a possibility that the stock might be overvalued, with investors expecting favorable results beyond reason and paying more for the stock today than it’s really worth.
A stock’s dividend yield is the ratio of dividend payment per share and the price per share. It is usually expressed as a percentage, and it can be helpful to think of it as the interest rate you receive for holding the stock.
Of course, not all stocks pay dividends which means this metric cannot be applied to all stocks. The dividend yield can also vary massively from industry to industry. However, when it comes to dividend-paying stocks, the dividend yield must be considered during valuation.
Analyzing the company’s dividend payments can also help us find trends that indicate the company’s growth in the future.
Do you plan to use fundamental analysis to value stocks? If so, you need to learn about margin of safety.
How to Value a Growth Stock
In the examples so far, we have been looking for stocks that are undervalued by the market (also known as value stocks). While the methods listed in this article can help us understand inherent value better, they are not perfect when looking for growth stocks.
Growth stocks can actually often feel overvalued when using the traditional valuation methods. For example, most growth stocks have little to no dividends as the companies use their profits to fund expansion instead of distributing it to the shareholders.
Fortunately, there are some solid models to identify growth stocks as well. The most famous example is CANSLIM by William O’Neil, which specifically considers all the essential aspects of a growth stock.
All in all, for the most part, growth stocks are valued based on their potential. TSLA is the most famous example of this: The company has seldom had impressive financial stats, but the fact that it’s innovating at a rapid rate—although not that profitably—made its investors believe that the stock will explode in value (which it has). This is why evaluation methods based on fundamental analysis usually don’t cut it for growth stocks.
What to Watch Out For When Evaluating a Stock
You might be tempted to fire up your trusted stock trading app and use these methods to look for the best opportunities right now, but it’s not that easy. Even the best analysts with cutting-edge valuation methods fail to watch out for the following when evaluating stocks:
Value traps refer to stocks that look undervalued, but they also have no potential for future growth. Looking at favorable multiples like price-to-book ratio, investors buy the stock expecting exponential growth but often end up with devastating losses.
In these stocks, the undervaluation is a confirmation of decline and not a signal for an opportunity. Taking a closer look at the companies usually reveals problems like lack of consistent profits, lack of a catalyst, and lack of interest from institutions.
Investors can stay clear of value traps by understanding the company’s context and using suitable valuation methods for the specific stock.
Inherent Market Risks
Mike Tyson once said, “everyone has a plan until they get punched in the mouth” when asked about a fight. So even though the quote doesn’t attribute directly to investing, it is still somewhat relevant.
Investors risk getting the metaphorical punch to the mouth every day by the markets. There is a meager chance of a global market crash, but when it happens, even the most promising stocks will not perform well. Factoring in the general market trends and evaluating the stock in the broader market context can also help investors prepare for black swan events.
Some stocks are unique and are not bound to any rules; they defy expectations and odds and can often polarize investors. For example, a company could be trading at a level where it seems to be highly overvalued yet keeps growing every year. Therefore, it is natural to assume that not all valuation methods will always be accurate and proven wrong by outlier stocks reasonably regularly.
Looking for advanced techniques? Learn how to use the Calmar ratio.
Other Evaluation Metrics to Keep In Mind
Along with the commonly used metrics listed above, a few more metrics are used for evaluating stocks. Some of them include:
The price-to-sales is the ratio between the market value per share and sales per share. It is very similar to the P/E ratio, except it uses just sales instead of all earnings. In some cases, like cyclical stocks, it can be used to determine the fair value when earnings might not be consistent through the years.
The debt-to-equity ratio lets us peek into how the company organizes its finances. It is a highly subjective ratio since the ideal benchmark will vary a lot depending on the industry and specific circumstances of the stock.
Free Cash Flow
Free cash flow is the net cash income of the company. It is an excellent metric to evaluate how effectively the company can generate cash. A company with low free cash flows might not have enough funds to meet its obligations.
Stock valuation is a complex process that requires a lot of practice. However, information is available more widely than ever, and online tools can do most of the heavy-lifting when it comes to analysis.
However, a wise investor should ideally know what values to expect and why to expect them. So now that you’ve armed yourself with these handy tools, we hope you use them responsibly.
How to Value a Stock: FAQs
Why Do Stocks Have Value?
Stocks have value because they represent an ownership share of a company and a claim to its future profits. Thus, a stock’s inherent value should be equal to the future net profits of the company at the least.
Why Do Stocks Gain or Lose Value?
Stocks gain or lose value due to market forces of supply and demand, among other things. The market value for stocks are decided by stock exchanges, and depending on investor confidence, the stock’s market value can either go up or down.
What is the Formula for Valuing a Company?
There is no universal formula for valuing a company. The correct valuation method will depend on the industry and taking into account the circumstances of the specific company.
How Do You Value a Tech Stock?
You can value a tech stock with several valuation methods. However, there are a lot of factors to consider when valuing tech stock. For example, while Microsoft and Netflix are both tech stocks, they have very different fundamentals and business approaches. When valuing tech stocks, it is imperative to consider the broader market it operates in and its specific approach.
Is It Possible to Find Growth Stocks with Valuation Methods?
It is possible to find growth stocks with valuation methods like CANSLIM. Valuation methods, at the end of the day, are just tools. They can only be as effective as the person using them.
What is the Fair Value of an ETF?
The fair value of an ETF should ideally be the fair value of the underlying assets it contains. However, since markets are constantly changing, the market value for ETFs can vary from their inherent value just like the stocks held in it.
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