Every investor who wants to beat the market must master the skill of stock valuation. Essentially, stock valuation is a method of determining the intrinsic value (or theoretical value) of a stock. The importance of valuing stocks evolves from the fact that the intrinsic value of a stock may be different from its current price. By knowing a stock’s intrinsic value, an investor may determine whether the stock is over- or undervalued at its current market price.
Stock valuation is the process of valuing companies and comparing the valuation to the current market price to see whether a stock is over- or undervalued.
Valuing stocks is a process that can be viewed as both an art and science.
Stock valuation can be classified into two categories: absolute valuation and relative valuation.
Types of stock valuation
Stock valuation methods can be primarily categorized into two main types: absolute and relative.
Absolute, or intrinsic, stock valuation relies on the company’s fundamental information. The method generally involves the analysis of various financial information that can be found in, or derived from, a company’s financial statements. Many techniques of absolute stock valuation primarily investigate the company’s cash flows, dividends, and growth rates. Notable absolute stock valuation methods include the dividend discount model (DDM) and the discounted cash flow model (DCF).
Relative stock valuation compares the potential investment to similar companies. The relative stock valuation method calculates multiples of similar companies and compares that valuation to the current value of the target company. The best example of relative stock valuation is comparable company analysis, sometimes called trading comps.
How to value a stock
Valuing stocks is a process that can be generally viewed as a combination of both art and science. Investors may be overwhelmed by the amount of available information that can be potentially used in valuing stocks (company’s financials, newspapers, economic reports, stock reports, etc.).
Therefore, an investor needs to be able to filter the relevant information from the unnecessary noise. Additionally, an investor should know about major stock valuation methods and the scenarios in which such methods are applicable:
1. Dividend Discount Model (DDM)
The dividend discount model is one of the most basic techniques of absolute stock valuation. The DDM is based on the assumption that the company’s dividends represent the company’s cash flow to its shareholders.
Essentially, the model states that the intrinsic value of the company’s stock price equals the present value of the company’s future dividends. Note that the dividend discount model is applicable only if a company distributes dividends regularly and the distribution is predictable.
2. Discounted Cash Flow Model (DCF)
The discounted cash flow model is another popular method of absolute stock valuation. Under the DCF approach, the intrinsic value of a stock is calculated by discounting the company’s free cash flows to its present value.
The main advantage of the DCF model is that it does not require any assumptions regarding the distribution of dividends. Thus, it is suitable for companies with unknown or unpredictable dividend distributions. However, the DCF model is more sophisticated from a technical perspective.
3. Comparable Companies Analysis
Comparable companies analysis is an example of relative stock valuation. Instead of determining the intrinsic value of a stock using the company’s fundamentals, the comparable approach aims to derive a stock’s theoretical price using the price multiples of similar companies.
The most commonly used multiples include the price-to-earnings (P/E), and enterprise value-to-EBITDA (EV/EBITDA) multiples. The comparable companies analysis method is one of the simplest from a technical perspective. However, the most challenging part is the determination of truly comparable companies.