What is Stock Valuation?
Stock valuation is, at its very core, a way of determining the intrinsic value (or fundamental value) of a stock. In finance, this term refers to the value of a company determined through fundamental analysis, and it is thus not related to the current market price or value of a company. By knowing the intrinsic value of a stock, an investor can assess whether the stock is over or under-valued at its current market price. He can then decide whether investing in a given company is the right or wrong choice.
The finance's rule of thumb
The leading theory behind the majority of valuation models is that a businesses’ value derives from the sum of all their future cash flows. However, a dollar today is not the same as a dollar tomorrow, so future cash flows need to be converted (or discounted) to present value. In other words, we need to take into account the time value of money.
When Science meets Art
Say, hypothetically, you could objectively know all the future cash flows of a company, and you had a target rate of return on your money already in mind. Then, you could compute the exact amount of money you should pay for that company. But, as it often happens, it is more intricate than this.
Stock Valuation is not easy in practice, and, at times, it can be an extremely complicated process. It is, to all effects, a combination of Science and Art. It is a Science since investors and analysts use precise models or methods to compute the intrinsic value of a stock. It is an Art because we can only estimate future cash flows. Future cash flows are not objective factual inputs. They need to be predicted, and, therefore, accurate estimation is one that requires skill and experience.
The three major valuation methods
Deciding the proper valuation method to value a stock can be an overwhelming experience. Some can be fairly straightforward, others can be quite frustrating. But, independently of their complexity or simplicity, no valuation method is always entirely correct. Each stock is different, and each industry has unique attributes. When analyzing an investment, you may need multiple valuation methods.
Below, we discuss the most popular methods of stock valuation.
1. Dividend Discount Model
The Dividend Discount Model, or DDM, is one of the simplest stock valuation methods. It assumes that a company’s value is represented by the dividends it pays to its investor. In essence, the intrinsic value of the company is defined as the present value of future dividends to investors.
2. Discounted Cash Flow Model
The Discounted Cash Flow model – or DCF – is another standard method of stock valuation. Under this approach, the intrinsic value of a company is related directly to the free cash flow it will generate. As such, it can be applied to any company that does not have a predictable dividend distribution. Nonetheless, it is ineffective when analyzing young companies that are yet to become cashflow positive.
3. Comparable Companies Analysis
Comparable Analysis, or Multiples Analysis, differentiates from DCF and DDM, as it focuses less on companies’ fundamentals. It instead compares several companies to compute their respective overall intrinsic value. It does so by using multiples, the most common of which are P/E (price-earning-ration) and EV/EBITDA (enterprise value-to-EBIDTA). Although it is relatively straightforward and can be applied to companies that are cashflow negative, it can be challenging to find good comparable companies.
In a Nutshell
Test yourself!
Public companies usually publish their financial statments on a quarterly and annual basis. You can find US-based public company’s balance sheets on the US Securities and Exchange Commission (SEC) website. Search for the 10-K, and you will be ready to go!
