Recently, we have been talking about value investors. So, today we’ll expand on the topic by discussing stock valuation. The concept of stock valuation relates intricately to the concept of value investing.
Value investing is the strategy of investing in stocks that the investor believes are worth less than their market value. In other words, stocks whose value the stock market is underestimating appeal to value investors.
Stock valuation is the process of assigning value to a given stock. But not just any value; stock valuation is all about determining a stock’s intrinsic value. A stock’s intrinsic value can be determined to be less than that of its market value. So in this case, it very well may be a stock that value investors are interested in.
In this article, we will delve deeper into stock valuation. We will discuss different types and methods of stock valuation. And most importantly, we’ll provide a guide for how to choose the best method for you and your investment strategy.
Why is Stock Valuation Smart for Investors?
As discussed in our blog about value investors, effectively valuing stocks can – to put it simply – make you a lot of money. Stock valuation is important because it can help you make important decisions about whether or not to invest in a given stock.
If you play it safe and invest only in stocks whose values are trending, you may have a hard time getting good value back. And this is where stock valuation comes into play. Determining the intrinsic value of a stock, and understanding that its value may be different than its market price opens up a whole new world of investing.
Being able to self-determine the value of a stock allows an investor to get a jump on the market. As a result, it’s very possible for the investor to cash out for much more than they put in.
Types, or Models, of Stock Valuation
There are two fundamental types of stock valuation methods: Absolute Valuation and Relative Valuation.
First, let’s discuss the Absolute Valuation model. The absolute valuation model focuses only on the company, or stock, at hand. This means that an investor employing the absolute valuation method will only look at data reflecting the company under consideration when making an investment decision. They would thus not compare that data to similar companies in the stock market.
The data points that investors typically look for when operating under the absolute valuation model can be found on the company’s financial statements. These inform the investor of financial information like a company’s cash flow and growth rate.
The second overarching type of stock valuation is relative valuation. As you can probably guess, relative stock valuation involves comparing the company at hand to other comparable companies.
When undergoing a relative stock valuation process, an investor will calculate the financial ratios of multiple companies and compare them. The most common ratio calculated and analyzed in a relative valuation model is the price-to-earnings ratio. This ratio comparing P/E amongst various companies can offer insight into whether or not a company is overvalued (or undervalued).
Stock Valuation Methods
Now that we have reviewed the two basic types of stock valuation, let’s look into specific stock valuation methods. We’ll determine whether they are based upon the theory of absolute valuation or relative valuation.
There are actually many different models of stock valuation. And financial analysts and investors tend to disagree on which are the best or even the most prominent.
There are two models, though, that are generally perceived as the most common:
The Dividend Discount Model (DDM) and the Discounted Cash Flow Model (DCF).
Dividend Discount Model
The Dividend Discount Model (DDM) falls under the Absolute Valuation category. It happens to be one of the most straightforward methods of performing an absolute stock valuation.
The purpose of this model is to calculate the intrinsic, or absolute, value of the company in question based on the dividends it pays to its shareholders. The reason practitioners of DDM employ dividends as their data point is that dividends don’t lie. As such, they are representative of real cash going out to shareholders. And as result, the value of this cash will provide information regarding the true value of the stock.
The Dividend Discount Model can be a good place to start if you are intrigued by Absolute Valuation methods. It is important to note, however, that DDM is only effective for companies that regularly distribute dividends amongst a stable group of shareholders.
Discounted Cash Flow Model
As we previously mentioned, the Discounted Cash Flow Model (DCF) is another very prominent stock valuation model. The Discounted Cash Flow Model calls upon a company’s free cash flow to calculate its intrinsic value.
Bet there are a few prerequisites for being able to use this model at all. First, does the company you are considering not regularly pay dividends to its shareholders? Then the DCF model can be a great place to turn.
The most important prerequisite for using the DCF model is that the company in question must have stable, positive, and predictable free cash flows. This will generally mean that ideal companies for the DCF model are mature firms past their early growth stages. You will find that in most cases, immature and high growth companies are not eligible for the Discounted Cash Flow Model.
To return to our analysis, the specific details of the DCF Model are fairly technically sophisticated. But the basic idea is to discount a company’s free cash flows to its present value, thereby calculating the intrinsic value of its stock.
Earnings multiple approach model
A third fairly common stock valuation model is known as the Earnings Multiple Approach.
The Earnings Multiple Approach is sometimes thought of as more straightforward. This is because it does not matter whether or not the company under consideration pays dividends to its shareholders.
In using this model, an investor would start by estimating the future earnings of the company over 5 or 10 years. And by doing so, the investor can create a theoretical earnings multiple.
After this, the investor will take into account:
- cumulative dividends
- the current stock price
- the company’s theoretical value calculated at the end of the hypothetical time period
The investor would then compare all of these figures. And the calculated results are what the investor believes to be the true value of the company’s stock.
The last stock valuation model we will look into is an example of relative valuation.
It is known as the Comparables Model, and it can be very useful mainly because it is a sort of one-size-fits-all model.
- Does the company you are looking into not pay dividends or have a positive and predictable cash flow?
- Or maybe you simply not have the time for complex financial calculations?
Then this is the model for you.
The Comparables Model, unlike the others we have discussed, does not involve finding a stock’s intrinsic value. Instead, it employs a relative valuation strategy and compares the stock’s price multiples to a benchmark.
Thus, where the stock’s price multiples fall along the benchmark will determine whether it is overvalued or undervalued.
This model has gained significant traction because it is so malleable. As such, there are a number of different price multiples that can be used in value determination. The most commonly used figure is the price-to-earnings ratio. But price-to-book ratio, price-to-cash flow, and many more can be used as well.
Are you relatively new to stock valuation and value investing and interested in relative valuation? Then the Comparables model can be a great place to start.
Using Stock Valuation in Your Investment Strategy
These various valuation models can be quite complex. We have only covered the tip of the iceberg when it comes to their intricacies and the calculations to find a stock’s intrinsic value. Of course, if you have any questions or concerns about any (or all) of these models we are here to help.
The fundamental thing to keep in mind when it comes to stock valuations, though, is that there are many different models for a reason. Successful value investors employ different valuation models with different companies, for different scenarios. And that is part of what makes it so complex.
Just when you have figured out the Dividend Discount Model seamlessly, the next company you’re considering will require you to run the Discounted Cash Flow Model. Oftentimes investors will even run multiple types of valuations on the same company. They do this just to make sure they have covered all of their bases.
And of course, personal preference comes into play as well. However you choose to go about your stock valuations, our team at Saddock Wealth is here to help.
We Can Help
At Saddock Wealth, our years of wealth management experience can help guide you toward financial prosperity. Schedule a meeting here, and we’ll discuss your best options.