The stock valuation fundamentals aim to value the “Intrinsic” value of the stock that shows the profitability of the business and its future market value.
Stock valuation is an important tool that can help you make informed decisions about trading. It is a technique that determines the value of a company's stock by using standard formulas. It values the fair market value of a financial instrument at a particular time. The reason for stock valuation is to predict the future price or potential market prices for the investors to time their sales or purchase of investments.
The stock valuation fundamentals aim to value the “Intrinsic” value of the stock that shows the profitability of the business and its future market value.
How to Value a Stock?
Valuing stocks is an extremely complicated 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.
Types of Stock Valuation
Stock valuation methods can be primarily categorized into two main types: absolute and relative.
Stock valuation is usually divided into two groups:
Absolute valuation intends to find the “intrinsic” value of the financial instrument. This method only focuses on the fundamental strengths of the company as the dividends, cash flow, and the growth rate for a single company.
1. Absolute
Absolute 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).
2. Relative
Relative stock valuation concerns with the comparison of the investment with similar companies. The relative stock valuation method deals with the calculation of the key financial ratios of similar companies and derivation of the same ratio for the target company. The best example of relative stock valuation is comparable companies’ analysis.
The methods used under Absolute Valuation are:
Dividend Discount Model (DDM):
This is one of the basic calculations of the Absolute Valuation model. It calculates the true value of the company by assessing its dividend payout to its shareholders. According to this method, the dividend is the representation of the actual cash flow of the company. It shows the true value of the company’s share.
Discounted Cash Flow model (DCF):
This method is suitable for companies that do not make regular dividend payments to its shareholders. The method uses the discounted future cash flow of the company to calculate its market value. The method is applicable for companies that pay a dividend or do not pay a dividend to their shareholders.
Comparable method:
The Comparable method does not use any kind of parameters to find the market value. Instead, it compares the stock price multiples to a set benchmark value. The rationale for this method is that the similar financial instruments carry the same market value.
Methods used under Relative Valuation:
Relative Valuation method uses ratio and other types of valuation methods to ascertain the value of the stock. The ratio is the most commonly used method as it is easy to calculate and is available at hand. The common ratios used are:
- Price per earning
- Earnings per share
- Growth rate
- Price-earnings-to-growth ratio
- Sum of Perpetuities method
- Return on assets
- Enterprise value
- Market capitalization
- Enterprise value-to-sales ratio
These ratios help the traders and the investors to calculate the fair value of stock and make informed decisions when transacting in the stock market.
Bottom line:
If you intend to invest in the stock market, you can make use of ratios and methods to evaluate the value of a stock. However, valuation methods are not the only tool to conduct trade, and you should consider other parameters such as history of the company and its trend before trading. It is also prudent to conduct valuations of different ratios and find the average of them to obtain a clear market value of the stock.
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