Valuing stocks: Here are the 4 best methods used by investors

Valuing stocks can be an intimidating prospect for many investors, especially those just starting out. However, there are several well-established methods to value stock that can help novice and experienced traders alike to make sound decisions when choosing stocks in which to invest.

In this article, we discuss four ways through which investors can go about valuing stocks. Specifically, determining how much a company is worth. Basically, there are four valuation methods widely used in the investment industry: Fundamental, Discounted Cashflow, relative valuation and looking at comparable transactions.

 

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4 methods to value stocks

 

1. Looking at the fundamentals

One popular method for valuing stocks is fundamental analysis. This type of analysis involves looking at the company’s financial statements – such as its income statement, balance sheet and cash flow statement – in order to assess the strength of the company’s operations and predict future performance.

Fundamental analysts look at different variables in these statements, such as revenue growth, margins, return on equity (ROE), debt levels and other key financial metrics. The goal is to identify companies that have strong fundamentals that could lead to future price appreciation.

 

2. Discounted Cashflow

A discounted cashflow (DCF) model is a technique to value companies by calculating the present value of future cashflows of an investment opportunity. The model estimates the intrinsic value of an asset or business by discounting the projected cash flows of that asset or business over time to their present value.

A DCF model is based on the principle that an investor should pay no more for an asset than the sum of all future cash flows it will generate, discounted back to their present value using a specified discount rate. By projecting future cash flow expectations from investments and then discounting those back to their present values based on a desired rate of return, investors can determine how much they should be willing to pay for any given asset or business today. This helps them make informed decisions about whether or not to invest in new projects or acquire existing businesses.

A DCF model is a powerful tool, but requires significant input data and assumptions, not to mention the correct data and assumptions, in order to produce reliable results. A modest change in just one or two assumptions –  such as the cost of capital, terminal growth or forex assumptions – can make a significant difference to the final valuation. Building DCF models can also be time-consuming for investors, particularly those that are inexperienced with it.

 

3. Relative valuation using valuation multiples

Valuing a stock using valuation multiples is a method of stock valuation that looks at the relationship between various financial metrics, such as earnings per share (EPS), and how the stock price relates to them. This type of analysis can be used to determine whether a company is trading at fair value relative to its peers and can be used to predict the future performance of the stock.

Multiples analysis looks at these ratios in comparison to those of similar companies in the same sector. This helps investors identify stocks that may be under or overvalued compared to their peers and can help them make informed decisions about which stocks to invest in.

The most common multiple used for stock valuation is the price-to-earnings ratio, or P/E ratio for short. P/E is calculated by dividing a company’s current stock price by its earnings per share (EPS).

Enterprise Value-to-Earnings Before Interest Taxes Depreciation and Amortization (EV/EBITDA) is another popular multiple used for valuation, especially when dealing with cyclical stocks or those operating in volatile markets. EV/EBITDA measures how much investors are willing to pay for each dollar of a company’s profitability before accounting for things like taxes, interest payments and depreciation expenses.

One final multiple often employed when valuing stocks, especially banks and insurance companies, is the Price-to-Book Ratio or P/B Ratio. The P/B Ratio is calculated by dividing a company’s current market share price by its book value per share – which represents what it would cost to replace all of its assets if it were to become insolvent – giving investors an indication of how much they are paying for each dollar of net asset value.

In all of these instances, a high ratio usually indicates that the share price is relatively high, which could be explained by investors potentially having high expectations for future growth while a low ratio may suggest that investors don’t expect much from the business going forward. But you might have a different view to the market, which could provide a buy or sell opportunity.

 

4. Comparable transactions

If a stock is or could be an M&A target, a way to go about valuing it could be to consider precedent transactions in the sector. For instance, if you think Star Entertainment Group (ASX:SGR) could be acquired, like Crown Resorts was, you could value that company at 8.5x EV/EBITDA, because that was the price Crown was acquired at.

This is the most objective method for valuing stocks. Analysts can compare transaction prices for similar businesses and extrapolate those findings to arrive at a more informed estimate of a stock’s worth. This valuation method helps eliminate some of the guesswork involved in other valuation methods, such as estimating future cash flows or relying on subjective inputs from management. This said, it is risky to own a stock simply because you think it will be acquired, because this may not happen.

 

Are there other ways to go about valuing stocks?

The four mechanisms we have outlined are the best ways for valuing stocks. But these are not the only factors investors should consider when looking at investment opportunities, though.

We think there are two additional factors that may help determine if a company is ‘worth’ its price. One of these approaches to valuing stocks is technical analysis or charting. Technical analysts use historical prices, volumes and other trading data to identify trends and patterns that could indicate support or resistance price points or reveal potential entry or exit points for trades. Technical analysts also study momentum indicators – such as moving averages, MACD (moving average convergence divergence) and RSI (relative strength index) – in order to determine whether a stock is overbought or oversold.

Secondly, investors may also consider qualitative factors when evaluating a stock, including things like brand recognition, management experience, market share, the competitive environment and industry conditions – all of which can influence a company’s future success or failure. Qualitative analysis typically involves researching the company’s background and management team in order to better understand their strategy.

 

Valuing stocks can be complicated, but is essential for long term success

Valuing stocks is a task all investors must undertake. However, it’s important for investors to remember that no single method will guarantee success when valuing stocks. Instead it’s important to combine different approaches when valuing stocks. This will give investors a more comprehensive understanding of how a particular stock might perform in the future.

Furthermore, it’s important not just to consider one set of figures, but rather analyse them over time so you can gauge the evolution of the business model and any shifts in strategy that could affect future performance.

By taking an holistic approach towards valuing stocks investors will be able take calculated risks while having confidence that their money is invested wisely.

 

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