Stock valuation is crucial for smart investing, as it means knowing how to judge if a stock is worth buying, much like deciding if a price is fair when you buy something. Investors use various methods to determine the right stock price based on financial factors, helping them make profitable decisions while minimizing risks. In this article, we’ll simplify these stock valuation concepts to empower both beginners and experienced investors to make better decisions in the stock market.
The Context
Stock valuation is crucial because it enables investors to assess a stock’s fair price and make wise investment choices.
When someone uses the phrase “fair value,” they typically mean something that is quite arbitrary or subjective. The methods used by analysts to determine (or estimate) any stock’s fair value vary greatly from one to the next. This is typically based on an examination of several financial and economic variables, including earnings, dividends, revenue growth, and industry trends.
Fair value analysis is a key idea that all DIY investors and competitive investment professionals must comprehend to engage in sensible and profitable investing. A stock’s intrinsic value can be estimated using a variety of financial models. The market price is then used to compare this value. The derived value is then compared to its market price.
⦿ If the market price is less than the intrinsic value, the stock is considered to be undervalued and a good opportunity to buy.
⦿ If the market price exceeds the intrinsic value, the stock may be overvalued and a selling opportunity.
In addition, stock valuation aids investors in recognizing potential risks and possibilities linked to a stock purchase. Being a specialized area of academic study, the most prominent valuation models are extensively addressed in our learning courses. This well-researched top 10 list will give you a decent idea of the models available to assist you in developing a sound ability to determine the fair value of a stock.
1. P/E Ratio (Price-to-Earnings ratio)
PE (Price-to-Earnings) ratio is a valuation model used to determine the relative worth of a company’s stock. It is calculated by dividing the stock price by the company’s earnings per share (EPS).
A higher PE ratio indicates that investors are willing to pay more for the company’s earnings, while a lower PE ratio indicates that they are less willing to pay for the company’s earnings. An expert suggestion is to utilize the industry average PE ratio as a point of reference.
2. P/B Ratio (Price-to-Book ratio)
The price-to-book (PB) stock valuation model compares the market value of a company’s stock to its book value. The book value of any company is the amount that its assets are worth as shown on its balance sheet. The ratio is calculated by dividing the market capitalization of a company by its book value.
A lower ratio generally indicates that a stock is undervalued, while a higher ratio indicates that a stock is overvalued. The PB ratio should not be used alone as a measure of a stock’s value; rather, it should be used in conjunction with other financial measures.
3. P/S Ratio (Price-to-Sales ratio)
P/S ratio, or price-to-sales ratio, is a financial metric used to value a company’s stock. It is calculated by dividing the market capitalization of a company (the stock price multiplied by the number of shares outstanding) by the company’s revenue.
A lower P/S ratio indicates that a stock is undervalued, while a higher ratio indicates that it is overvalued. This ratio can be used to evaluate businesses in the same sector and to monitor changes in a company’s valuation over time.
However, it should be noted that the P/S ratio (just like the P/B ratio) is one of many factors that should be considered when evaluating a company’s stock and should not be used as a sole indicator of a stock’s value.
4. P/CF Ratio (Price-to-Cash Flow ratio)
The price-to-cash flow (P/CF) ratio is a financial metric used to evaluate a company’s value. It is calculated by dividing the market capitalization of a company (i.e. the stock price multiplied by the number of shares outstanding) by its cash flow from operations.
A lower P/CF ratio may indicate that a stock is undervalued, while a higher ratio may indicate that it is overvalued. This ratio is used by investors and analysts to compare a company’s valuation to its cash flow generation.
5. Dividend Discount Model (DDM)
The Dividend Discount Model (DDM) is a method used to value a stock based on the theory that its price is equal to the present value of all of its future dividends. The model calculates the intrinsic value of a stock by discounting the expected dividends to the present using a required rate of return, also known as the discount rate.
The basic formula for the DDM is: Intrinsic Value = (Expected Dividends / Discount Rate) + (Expected Dividends / (Discount Rate – Dividend Growth Rate))
6. Free Cash Flow To Equity (FCFE)
The free Cash Flow to Equity (FCFE) valuation model is a method used to determine the intrinsic value of a company’s equity by estimating the amount of cash that can be distributed to equity holders after all necessary investments have been made.
It is calculated by taking the free cash flow (FCF) and subtracting any net new investments in the business. This model is commonly used in discounted cash flow (DCF) analysis to estimate the present value of future cash flows available to equity holders.
7. Free Cash Flow To Firm (FCFF)
Free Cash Flow to Firm (FCFF) is a financial model used to value a company by estimating the amount of cash flow that is available to all of the company’s stakeholders, including bondholders and shareholders. It is calculated as operating cash flow minus capital expenditures and is used to determine the intrinsic value of a company’s stock.
FCFF is considered to be a more accurate measure of a company’s financial performance than earnings or net income, as it takes into account both the company’s operational efficiency and its ability to generate cash flow.
8. Gordon Growth Model
The Gordon Growth Model is a method of valuing a stock using a dividend discount model. The model states that the value of a stock is equal to the present value of its future dividends. The formula for the Gordon Growth Model is:
Stock Value = D1 / (r – g)
Where:
▶D1 = the next expected dividend
▶r = the required rate of return
▶g = the constant growth rate of dividends
The Gordon Growth Model assumes that dividends will grow at a constant rate in perpetuity and that the required rate of return remains constant. It’s important to note that the Gordon growth model is one of the simplest ways to value a company but it has several assumptions that might not always hold in the real world
9. Earnings Power Value (EPV)
The Earnings Power Value (EPV) model is a method of valuing a stock by determining the intrinsic value of a company based on its earnings power. The EPV model calculates the present value of a company’s future cash flows, using an estimated “normal” level of earnings and a discount rate.
The intrinsic value is then compared to the current market price of the stock to determine if it is undervalued or overvalued. This model is based on the idea that the value of a company is determined by its ability to generate earnings, rather than by its assets or revenue.
10. Discounted Cashflow Model (DCF)
The discounted cash flow (DCF) model is a method of valuing a company’s stock by estimating the present value of its future cash flows. This is done by forecasting the company’s future cash flows, discounting them back to the present using a discount rate, and then summing them up.
The result is the intrinsic value of the company’s stock, which can be compared to its current market price to determine if it is undervalued or overvalued. Please be aware that, when applied properly, this stock valuation approach is by far the most complicated and yet derives wonderful results.
♻ Pro Tip: DCF cannot be applied to stocks in the banking sector because these institutions are highly leveraged and do not reinvest their debt in their businesses; instead, they use it to produce new products.
Conclusion
With so many options available, you as an investor must be aware that there is no one “optimal” stock valuation model because different models serve different purposes for various businesses or industries. Although stock valuation techniques help figure out a stock’s intrinsic value, utilizing them without the right calibrations or experience could yield several negative effects.
Primarily, because they are dependent on historical data, these models might not be able to predict future performance precisely. Second, these models’ inputs, such as earnings and revenue, may be manipulated and not always accurately reflect a company’s genuine financial health. Thirdly, these models ignore macroeconomic variables that have a big influence on stock values, like interest rates and economic growth.
Last but not least, a variety of assumptions used in stock valuation models, such as steady growth rates, may not always hold in practice. These limitations should be considered when using stock valuation models and interpreting their results. If you intend to invest for the long term, you may also enroll in one of our special courses that combines mentor support with organized learning to help you grasp and execute these ideas forever.
Did you find these stock valuation models informative?
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