You must’ve come across words like stocks, equity, and valuation thrown around during work conferences or among the older people in your family. Perhaps that’s what piqued your curiosity and brought you here. And why wouldn’t it? Stock valuation can be an interesting yet serious game; only here, you’re playing against an ever-changing market.
In simple terms, stock valuation is the process of evaluating and determining the intrinsic value of stocks held by a company. It comprises an analysis of the interplay among various factors in the market that decide whether a stock is overvalued or undervalued. Think of it like a theory-building activity based on numbers, valuation methods, market trends, performance, and industry analyses of a company. Except once you have your theory, you actually bet against it by putting real money where your mouth is. You make investments with the aim of achieving long-term gains, which also determine the accuracy of your stock valuation.
Why Stock Valuation Matters
Stock valuation is a crucial source of bread and butter for investors. In a perfectly competitive market, like the one we transact in, the opportunities for investing are numerous. Such a deal requires us to be realistic as well as strategic about the investments we make. And a good investment is only as strong as the careful analysis that goes behind it. A good investment is capable of multiplying over the years while simultaneously refining your stock valuation skills. It supports prudent financial decisions and insulates you from overexpenditure as well as risks.
Stocks are evaluated based on a couple of methods and models. These models cover an overarching analysis of a few important facts that influence stock prices:
- Financial health of the company
- Annual earnings
- Assets, liabilities, cash flows, and other payouts
- Market value of company stocks
- Risks associated with the company
- Comparative value of the company as per the industry
- Scope for growth
- Time sensitivity of the investment
Let’s dive in and understand how these methods and models work to provide accurate stock valuation for high returns.
Step-by-Step Guide To Stock Valuation Models For Long-Term Success
In this guide, we’ll understand some of the most popular models and methods used in stock valuation and how they are applied. But let’s start from the beginning.
Understand The Basics
The first step when determining the intrinsic value of a company’s stock is to gain a fundamental understanding of its financial backbone. Ask questions like:
- Is the company in a lucrative industry?
- What is its existing revenue, and how does the revenue from previous years compare?
- Are there evident growth trends?
- How does the income and cash flow statement of the company look?
- How high or low stakes are the risks?
These primary questions will come in handy when you move on to the next steps and apply math to your valuation hypothesis.
Choose a Method
Once you’ve grasped the fundamentals, understand how different methods and models apply when evaluating stocks.
- Absolute Method
The absolute method is designed to determine the absolute value. Also known as the intrinsic or true value of the company, it is determined using a method called the Discounted Cash Flow (DCF) model. The company’s balance sheets are referred to in order to determine cash flows, assets, liabilities, and dividend payments being made by the company. The absolute value, once calculated, is compared with the market price of the shares of the company. This enables an investor to understand whether the company’s stocks are undervalued or overvalued.
The Discounted Cash Flow model seeks to estimate the projected future cash flows of a company and adjust them to the present day. This adjustment is done by applying a discount rate. If the DCF ranks above the current price of stocks, then that indicates undervaluation. It essentially means that you’ll have positive returns in the long term.
Example:
Step 1: Let’s suppose you project the future cash flows of a company as follows:
| Year | Cash Flow (in $) |
| 1 | 10 |
| 2 | 20 |
| 3 | 30 |
| 4 | 40 |
Step 2: You also determined the discount rate to be 10%, having done a thorough risk and time analysis.
Step 3: You apply the formula now. The formula to calculate the present value of the future cash flows is:
Cash Flow/(1 + Discount Rate)^n
“n” indicates the year of cash flow estimation.
Step 4: The discounted cash flow for each year is calculated.
| Year | Cash Flow | Discounted Cash Flow |
| 1 | 10 | 9.09 |
| 2 | 20 | 16.53 |
| 3 | 30 | 22.54 |
| 4 | 40 | 27.32 |
Step 5: Add up all the values of all the years. The total present value, therefore, comes to $75.
This is what the company is worth today. You can now determine whether the company is undervalued or overvalued based on the share price it is listed and make an investment. Other models like the Discounted Asset model, Dividend Discount model, and Discounted Residual Income Method are also used in stock valuation. All of them employ a specific rate of return, like the discount rate in the DCF model, to determine whether investing in a company will have positive returns.
- Relative Method
The relative method involves a comparative analysis of similar assets in the industry/market to determine the value of a company’s stocks. It is done by comparing ratios through a popular valuation method known as the price-to-earnings ratio. The P/E ratio is calculated through the following formula:
P/E = Stock Price/Earnings per share
Example:
Step 1: Let’s suppose a company’s share price on the present day is $100, and its earnings per share have been $10 over the previous year. This means 10:1 is the P/E ratio of the company.
Step 2: The P/E ratio indicates that the investors pay $10 every time the company makes an earnings of $1. A lower P/E ratio is indicative of undervalued stocks, and a higher P/E is indicative of overvalued stocks.
You can also choose to opt for similar methods, like the price-to-book ratio or the price-to-sales ratio.
Make An Investment
Most experienced investors advice in favour of investing in undervalued stocks. A company with a high intrinsic value, despite being priced wrongly or facing temporary challenges, has higher chances of growth and returns. A combination of the above-mentioned methods enables investors to conduct meticulous analysis and helps make profitable investments.
Final Thoughts
In an ever-changing market, investment takes discipline, attention to detail, and a strong instinct for market predictions. This is not one of those things you gain by reading books and taking advice. Most big investors, like Warren Buffett, grew organically. They applied different analytical models, experienced setbacks, learned from them, and practised sniffing the market for opportunities. An enduring figure in the investment business, walking in the footsteps of the “Oracle of Omaha”, is no small feat in itself. Moreover, it is sure to help any investor thrive.
