How do analysts value stocks? Here are 3 key ways to judge what a stock is worth

Nick Sundich Nick Sundich, July 24, 2023

In this article we answer the question ‘How do analysts value stocks?’

By knowing how they do it, you can at least see where analysts are coming from in their valuation of companies. But hopefully, you can put some of these skills into practice for yourself and make your own decisions about whether or not to buy and sell a stock, dependant on whether or not your analysis shows the stock is undervalued or overvalued.

 

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The 3 answers to the question: How do analysts value stocks?

 

1. DCF

DCFs, or Discounted Cash Flows, are an important financial tool used to assess the value of a company. They involve taking into account future cash flows generated by a business and discounting them back to their present value. In order to do this effectively, the cash flows need to be projected forward in time and then discounted by an appropriate rate of return or cost of capital. This is because money has time value – future cash flows are not worth as much as current ones due to inflation and other factors.

The DCF model takes into account a variety of factors that can affect future cash flows, such as economic conditions, changes in demand for products and services, cost of capital and investments made within the company. It also considers the risk associated with each factor by accounting for both upside potential and downside risk. To ensure accuracy in projecting cash flows, assumptions must be made about these factors which must be regularly updated over time.

Using DCFs allows investors and analysts to estimate the fair market value of a company’s stock or bond given its future expected cash flow streams. This makes it possible to compare companies across industries or sectors on an apples-to-apples basis using the same set of assumptions and judgment criteria and determine which one is likely to generate higher returns for shareholders over time.

 

2. Multiples

Multiples are a useful tool that investors use to value stocks. They are derived from the company’s fundamental financial metrics, such as earnings before interest taxes, depreciation, and amortization (EBITDA) or price-to-earnings ratio (P/E). The multiple is then applied to the company’s current market capitalization or enterprise value to predict what the stock price could be.

For example, if a company has an EBITDA of 10 million dollars and an average industry multiple of 8x for similar companies, then it can be valued at $80m. Similarly, if a company has a P/E ratio of 12x and its current EPS is $3 per share, then it implies the stock is worth $36 per share – and theoretically should get there eventually.

These multiples can provide insight into whether a company’s stock is undervalued or overvalued. For example, if a company has an EBITDA of 10 million dollars but is trading with an industry multiple of only 5x, this signals that the stock might be undervalued compared to its peers. On the other hand, if a company’s P/E ratio is 20x while its peers only have a P/E of 15x (or perhaps the average P/E of a benchmark index is <20x), this indicates that it might be overvalued.

 

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3. Comparable transactions

Comparable transactions, also known as benchmarking, is an important tool for valuing stocks. It involves comparing similar transactions of publicly traded companies to estimate a price range of a stock. The data collected from comparable transactions can be used to assess the current value of a target company’s stock.

For example, if you are trying to determine the market price of a stock that is about to go public, you would look at other similar companies that have recently gone public and use their initial public offering (IPO) prices as a starting point for your analysis. Looking at these previous investments can help give you an idea of the potential range of values that stock may have. This range can then be adjusted according to various factors such as sector growth or economic conditions.

You can do the same if you think your company can be an M&A target – look to previous transactions to give an understanding of how much Company A’s shares might be worth. For instance if a company in your sector was acquired at 10x EV/EBITDA a few months ago, you might conclude your own holding should be worth that too.

Of course, you may need to adjust that accounting for differences between your own company and the one that was bought – both the good and bad.

 

What’s the point of all this?

Overall, these mechanisms provide investors with valuable information when trying to assess the value of stocks and determine whether they should buy or sell them.

By doing so, investors can give themselves the best possible chance of making money. Because after all, that’s why investors invest!

 

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