Definition of Stock Valuation
- Stock valuation is the process of determining the current (or projected) worth of a stock at a given time period.
- There are 2 main ways to value stocks: absolute and relative valuation.
- Absolute valuation is a method to calculate the present worth of businesses by forecasting their future income streams.
- Relative valuation is a method that compares a stock value to that of its competitors and peers within the same industry to assess the stock’s worth.
How to Value a Stock?
- Absolute valuation is calculated through the discounted dividend model (DDM) method and discounted cash flow (DCF) method where you only focus on the stock and look at its dividends, cash flow, and growth.
- The DDM method allows you to value a company by looking at the sum of all the future dividend payments that have been discounted back to the net present value.
- Another method to use is the discounted cash flow (DCF).
- Often companies don’t pay dividends every quarter or every year hence making their payouts irregular.
- The DCF the perfect method to use when in a situation like this.
- The DCF method asks you to discount all the future cash flows of the company to the present value.
- Relative valuation compares a stock value to its competitors and peers within the same industry. The main relative valuation ratios include price to free cash flow, enterprise value (EV), operating margin, price to sales, and price to earnings.
- The most popular ratio is the price to earnings ratio.
- Price to earnings (P/E) ratio is calculated by dividing the stock price by its earnings per share (EPS) and is expressed as a multiple.
- A company with a stock of a higher P/E ratio than its peers is considered overvalued, while a company with a relatively low P/E ratio in comparison to its stock is considered undervalued.
Why is Stock Valuation Important?
- Stock valuation is important because it can be used to identify whether a stock is overvalued, undervalued, or is at market price.
- Investing in a company that is overvalued provides a huge downside risk. Whereas, investing in a company that is undervalued can significantly reduce the risk.
- Therefore stock valuation enables you to understand your risk.
Stock Valuation in Practice
- The DDM can be calculated through the Gordon growth model (GGM).
- The GGM assumes that all future dividends will grow at a constant rate.
- The GGM can be calculated through the following formula:
D0 = D1 ÷ (r – g)
(Where D0 = current value of the stock, D1 = expected dividend payment, r = cost of equity, and g = constant growth rate)
- For example, if a company lists its stock price at $50, has a required rate of return at 15% (r), pays a dividend of $1 per share you own, and has a constant growth rate of 6% then how would you calculate the stock value?
- $1 ÷ (0.15 – 0.06) = $11.11
- Therefore, you would say that the stock price is overvalued as the GGM says that the stock price should only be $11.11.
- The DCF can be calculated through the following formula:
[CF ÷ (1+r)^1]
(Where CF = cash flow, r = interest rate, and n = number of periods)
- Say a company currently has a cash flow of $10,000 and has a growth rate of 3% for one year, how do you calculate this?
- [10,000 ÷ (1 + 0.05)^1] = $9070.29
- Hence the current value of the cash flow is $9070.29.