As a first-time investor, deciding which evaluation method to use when trying to understand what is stock valuation can be overwhelming. Some methods are pretty straightforward, whereas others are more complicated. 

But there is no specific method that will work flawlessly for all. Every stock is different, and each sector has unique characteristics that require multiple evaluation methods. So, let's look at the different methods and how to use them.

What Is Stock Valuation - Table of Contents

What Is Stock Valuation?

Stock valuation is the most crucial skill that investors need to perfect to determine if their stocks are over or underpriced when it comes to the growth charts of a company. Based on business fundamentals, the intrinsic value may not match the current market price. This is mainly due to the demand and supply factors of the market. But, applying stock valuation can determine the fair price of a share. Active investors believe that the intrinsic value of stocks is separate from current prices and apply a sequence of metrics to compute the actual value when compared to real market prices. 

But another group of investors, passive investors, base their theories on the efficient market hypothesis. This means that the market price is based on all the information available. So, it is the real-time value of the stock. These passive investors recommend investing in EFTs or index funds that reflect market returns rather than calculating the different stock values to outsmart the market. 

Trying to understand what is stock valuation is a complex process and can be overwhelming. But, investors need to focus more on relevant details and filter out any noise in the process.

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What is The Importance of Stock Valuation?

The following factors showcase the importance of stock valuation for investors: 

• It is used to identify whether a stock is undervalued, overvalued or is at the best market price.

• Investment in a company that is overvalued has a considerable downside risk.

• But, investing in an undervalued company reduces the risk significantly. 

• So, stock valuation helps investors understand the risks involved.

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What are The Different Types of Stock Valuation?

Two primary types of stock valuation methods in the market exist - Absolute and relative. 

1. Absolute Stock Valuation

When understanding what is stock valuation, you first need to look at the different types of stock valuations in the market. The absolute type of stock valuation relies on the fundamental analysis of businesses. It is based on the valuation of multiple financial details derived from financial statements focusing on growth rates, cash flow and dividends.

Calculating a stock's value via the absolute method involves the calculation of the Dividend Discount Model (DDM), Discounted Cash Flow Model (DCF), Residual Income Model and Asset-based model. But, just like the name suggests, the absolute method does not compare one business'sbusiness's performance with its competitors.

2. Relative Stock Valuation

The Relative Stock Valuation method compares similar companies' financial ratios and the derivation of the same metrics for the business in focus. The popular way to do this is by comparing company data analysis.

Calculation of the P/E ratio is the cornerstone of the relative valuation method. For example, if the P/E ratio of the present business is less than its competitors, then the stocks are undervalued. Let's take an example to understand this better. 

Business A reported diluted earnings per share at the end of the fiscal year ending March 2020 at Rs. 5.50, and the price during the calculation was Rs. 250. So, to get a P/E ratio, we divide the share price by EPS. 

P/E ratio = Rs (250/5.50) = Rs. 45.45

So, an investor can get the EPS value from a business's financial statements, and the price is the present value of the shares in the market.

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What are Some Stock Valuation Methods?

Now that we know the different types of stock valuation, let's look at some of the valuation methods available to investors and when it is appropriate to use them. 

1. Dividend Discount Model (DDM)

The Dividend Discount Model, or DDM, is one of the most basic absolute valuation models. The dividend discount model helps calculate the ''true'' value of the firm based on the dividends the business pays out to its shareholders. 

The justification for using these dividends in the valuation of a company is that these dividends represent the actual cash flow being passed on to a shareholder, so the present value of this cash flow provides a value for the worth of these shares. 

The first step in this method is determining if the business pays a dividend. The second step is to understand if the dividend is predictable and stable. The businesses that offer stable dividends are mature blue-chip companies in developed industries. These types of businesses are best suited for DDM valuation models. 

2. Discounted Cash Flow Model (DCF)

We know that all companies do not pay their dividends equally. So, what happens when a company's dividend pattern is irregular? In that case, investors need to use the Discounted Cash Flow Model. 

In this case, rather than looking at dividends, the DCF model uses the firm's discounted future cash flow to evaluate the business. One of the most significant advantages of this model is that it can be used for firms that do not pay dividends. 

The DCF method has multiple variants, but the most common one is the 2-stage DCF model. In this variation, the free cash flow method is generally forecasted for 5-10 years, and a terminal value is calculated to account for the cash flow before the forecasted period. 

The first requirement to use this model is for the company to have a positive and predictable cash flow process. Based on this, investors can check multiple small companies and non-mature firms excluded due to the large capital expenditures these businesses encounter.

To use the DCF model effectively, the target brand should have a stable and positive free cash flow.

3. The Comparable Model

The last model in this list is the catch-all model, which can be used when no other model works or if you do not want to spend time crunching numbers unnecessarily. 

The comparable model does not attempt to look for the stock's intrinsic value like the other two. Instead, it compares the stock valuation's price multiples to a benchmark that helps determine if the stock is overvalued or undervalued. 

The reasoning behind this is based on the Law of One Price. This states that two similar stocks or assets should sell for similar prices. This ideology is one of the reasons why this model is so popular with investors. 

Another reason why the comparable model can be used is due to the multiples that are used to measure the stock valuation. 

It includes values such as Price-to-Earnings, Price-to-Book, Price-to-Sales, Price-to-Cash Flow, and others. Out of these ratios, the P/E ratio is one of the most commonly used values as it focuses on the company earnings, a primary driver of the investment value.

So, when can P/E be used for comparison?

You can typically use the P/E when the company is publicly traded as investors can check both the stock prices and the company earnings. 

Also, the company generates a positive earning as the comparison using a negative P/E multiple is meaningless. Lastly, the earnings quality must be strong. This means that the earnings cannot be volatile, and the accounting practices used by the management should not distort the report.

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Common Stock Valuation Formula

The equation to establish DGM or Dividend Growth Model is:

Stock Price = D1/(r-g) 

Where, 

D1 = expected dividend in the first year 
r = discounted rate 
g = growth rate

Some ways to determine the discount rate depending on the cost of capital. Another way to figure D1 is by the formula: 

D1= D0(1+g) 

Let's say that an investor wants to buy some shares in a business. The business pays a dividend (D0) of $5.00, and the dividend yield(g) is 2%. So, 

D1= 5.00 (1.02%) 
D1= 5.10 

So, now that we know what D1 is, we can calculate the stock price: 

Stock Price = D1/(r-g) 
Stock Price = 5.10/ (0.10-0.02) 
Stock Price = 5.10/0.08
Stock Price = 63.75

How to Value a Stock?

The absolute valuation method is calculated using the Discounted Dividend Model or the Discounted Cash Flow method, where the main focus is on the stocks, dividends, growth, and cash flow. 

This method allows investors to value the company by looking at the sum of all the future dividend payments discounted back to the present net value. Another way to calculate the stock value is by the Discounted Cash Flow or DCF method. 

For relative valuation, comparing stock values with competitors in the same industry is better. The main ratios include price-to-free cash flow, price-to-sales, price-to-earnings, enterprise value, and operating margin. 

In this method, the most popular ratio used is the price-to-earnings ratio which is calculated by dividing the stock prices by the EPS or Earnings per share. The higher the P/E ratio of a company than its competitors, the more the stocks are overvalued. 

Stock Valuation Example Practice

If we were to understand the actual utility of the DDM method, then let us calculate the stock value using the Gordon growth model. The GGM method assumes that all dividends grow at a constant rate. So, the formula used is,

D0 = D1 / (r-g) 

Where, 

D0 = current stock value 
D1 = expected dividend payment 
R = equity cost 
G = constant growth rate 

So, let's say a business lists its stock price at $100 and offers a return rate of 15% (r), with a dividend of $5 per share you own. The constant growth rate is 6%. So, the stock value is: 

= $5 / (0.15-0.06) 
= $55.55

So, as per GGM, the stock value is overvalued, as it should be only $55.55. 

Again using the DCF method, stock value can be calculated using the formula: 

[CF/(1+r)Λ1] 

Here, 

CF is the Cash Flow 
R is the Rate of Interest 
N is the period 

So, let's say a business has a cash flow of $1000 and a growth rate of 5% for 1 year. Then the current value of the cash flow is: 

1000/(1+0.05)Λ1
= $952.380

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Stock Valuation FAQs

1. What do you mean by stock valuation? 

Stock valuation is the process of determining a company's stock value relative to its share prices. The stock prices fluctuate based on the demand, supply and other options but do not reflect their actual value. 

2. What are the methods of stock valuation? 

There are 3 methods of stock valuation - Dividend Growth Model, Discounted Cash Flow Model and Comparable Company Analysis Model. 

3. What is an example of stock valuation? 

One of the most common examples of stock valuation is a business's market capitalization. This considers a company's share prices and multiplies them by the total outstanding shares. For example, if a company's share price is $5 and it has 1 million shares outstanding, its market capitalization is $ 5 million. 

4. What is the primary purpose of stock valuation? 

Stock valuations aim to provide a value to the intrinsic potential of a stock. It shows whether a stock will be profitable in the future market. 

Conclusion

When it comes to understanding the fair value of stocks, it is essential to understand what stock valuation is. This gives investors a comparative analysis of how businesses perform and will perform in the long run. But there is more than one way to check and interpret stock valuation. 

So, investors need to consider the strengths and weaknesses of a company while checking its value. Before jumping into the world of stock valuation, it is essential to study more about the art and how to interpret it.