Best Ways to Value a stock

Relative valuation is most commonly used by investors for 2 reasons:

It is simpler and provides a good insight into the “pricing” of the stock (i.e. it is a demand vs supply situation), rather than its value.

If you want to trade in stocks and don’t want to stay invested for the long-term, relative valuation is your best bet.

Relative valuation involves analyzing the stock’s price using several ratios such as:

- P/E: Price to Earnings Ratio

- P/B: Price to Book Ratio

- EV/EBITDA: Enterprise Value to Earnings Before Interest, Taxes, Depreciation, and Amortization Ratio

- PEG Ratio: Price to Earnings Growth Ratio

This list is inclusive. Analysts use plenty of other ratios. Now an obvious question you might have when looking at so many ratios is – which one should you use?

Well, that depends on the type of company you’re looking at. But most news articles use the P/E ratio for valuing a stock. You can compare the company’s P/E Ratio to the industry’s average P/E ratio to see if it’s over or underpriced. 

The simplest way to value a stock is the dividend discount model. The model assumes a constant cash flow into perpetuity for the company and discounts it at a constant rate. The model is most suitable for mature companies with a plateaued growth rate.

Formula:

Dividend for Year 1/(Cost of Equity – Dividend growth rate)

A variation of the DDM is the Gordon Growth Model where you assume a constant growth rate for the company. You could use the DDM to discount cash flows of multiple years, before you finally estimate a constant growth rate beyond Year 2/3/4, as the case may be, into perpetuity. 

To do research and understand the stocks of a company, you should understand how the company works. Ensure that you know where the revenue comes from. Ask questions like:

- Who are the company’s biggest customers? 

- From where does the revenue come? 

- Does it come from consumer sales, advertising, or somewhere else?

- Is it a young company or an established giant?

- Are there regulatory issues the industry must overcome?

- How will the company fit in the future of the industry?

- Will it be able to adapt or change?

- Does it have any competitive advantage?

You will receive a lot of data from the 10-K and 10-Q forms, so it is important to know which information is useful to you. These are some of the factors that you should look for:

- Net income: Check if the company finished with a gain or a loss at the end of the period. You can find the number at the bottom of the income statement. It equals total revenue minus depreciation, expenses, taxes, and more. 

- Price-to-earning ratio: The P/E ratio is calculated by dividing the market value of a share by the earnings per share. The ratio is often calculated based on the stock’s past performance, it can show you how the market thinks it will perform in the future. If the company has a relatively high P/E ratio as compared to its competitors, then it means the market expects healthy growth in the future. 

- Return on equity: This factor helps you understand how effectively the company uses its investors’ money and returns investments to its shareholders.

This is not the entire list, but these factors are a good way to start your stock research.

Intrinsic valuation is a more involved process, as compared to relative valuation where you only have to plug in a numerator and denominator to obtain a ratio.

Intrinsic valuation is what, as per your estimates, the price of the stock “should” be. It’s the actual value of the stock – but again, based on your estimates.

Intrinsic valuation involves discounting the expected cash flows of the company under the assumption that such cash flows will continue into perpetuity.

Here are the estimates you may have to make for an intrinsic valuation:

·        The expected cash flows of the company

·        Earnings growth

·        Reinvestment (planned/unplanned)

·        Dividend Payout

·        Risk (Beta)

Ideally, you’d use an excel sheet to operate the discounting mechanism as you input the figures into the boxes. More experienced analysts use the SOTP (sum of the parts) method, which is nothing but fancy talk for summation of intrinsic value of different parts of a single company.

The price to earnings or P/E ratio is one of the ways to understand stock growth and value. A stock can increase in value without significant earnings, but the P/E ratio decides if it can stay up. Without earnings to back up the price, the stock will eventually drop down. It is important to compare P/E ratios among companies in similar markets and industries. Ideally, the P/E ratio should be more than 15 and less than 18. Also, this information is for people who are just starting and trying to understand the stock market. You can listen to investment podcasts to gain more information. My favorite is the ColdBrew podcast.

If you have a brokerage account, then utilize the resources that come with it. Most firms offer in-depth reports or a database of information that will help you in your stock research. Also, it is a good idea to ask the qualified broker about their opinion on the potential stock purchase. If you don’t have a brokerage firm, you can still do your research from sites like Yahoo Finance.

Start by doing qualitative research and reviewing the company’s financials. Pull together a few documents that the companies are required to file with the U.S. Securities and Exchange Commission:

Form 10-K: This is an annual report that includes financial statements that have been audited independently. From this, you can review a company’s source of income, its balance sheet, how it handles its cash, and its expenses and revenue.

Form 10-Q: This shows a quarterly update on financial and operations results.

There are mainly two types of stock analysis:

Fundamental analysis: Fundamental analysis aims to determine whether the current price of the company accurately reflects its future value. It involves researching the financials of the company and looking at factors like price-to-earnings ratio and earning per share, and more.

Technical analysis: Technical analysis utilizes data based on the market activity like prices and trading volume. Technical analysis is usually done by professional researchers and they have tools, charts, and trends to do the analysis. They can predict the future price movements of the stock.

For the valuation of stock, looking at the company’s cash flow statement, dividend, and growth rates show how the company is performing. There are 2 further types of absolute stock valuation:

1.Dividend Discount Model

This valuation model applies to companies that regularly pay steady dividends. In this model, the dividends paid to the shareholders are the company’s cash flows. For the valuation of stock, the present value of the company’s future value of the stock is calculated. 

2.Discounted Cash Flow Model

The discounted cash flow model takes guessing and assumptions out of the equation. It does not rely on dividends and is majorly used for company’s that pay unstable dividends because the next dividend payment is simply unpredictable.

For stock valuation, the present value is calculated by discounting the company’s free cash flows.