Stock Valuation Techniques for Beginners

Stock valuation or share valuation is a method that determines the intrinsic or theoretical value of a stock in future. It is important as it helps investors in identifying how a stock will perform in future. This helps them make the decision of whether they want to invest in a stock or not for gaining profit. Since the intrinsic value may differ from the current price of the stock, stock valuation becomes necessary. In this article, we will be discussing stock valuation techniques for beginners.

Table of Contents

• Introduction to Stock Valuation
• The Importance of Stock Valuation in Trading
• Stock Valuation Strategies for Beginners
• How is the Stock Valued?
• Methods of Stock Valuation
  • Price-to-Earnings (P/E) Ratio
  • Dividend Discount Model
  • Discounted Cash Flow Model 
• How to Choose the Appropriate Stock Valuation Method?
  • Absolute Valuation Models
  • Relative Valuation
• Factors Influencing Stock Valuation
• Common Mistakes to Avoid in Stock Valuation
• Pros and Cons of Different Stock Valuation Methods

Introduction to Stock Valuation

Stock valuation is an important metric for increasing the chances of compounding money. With the right set of valuation techniques, stocks with growing curve can be identified. Investors highly rely on valuing stocks to reduce their losses.

Definition of Stock Valuation

Stock valuation or share valuation is a process of company valuation and comparing its valuation to the current market price. This is done to determine if a stock is under or overvalued. This is a theoretical method of calculating the value of companies and their stocks. It is based on the fundamental aim to provide an estimate of the stock's intrinsic value. This is based on future cash flow prediction and the profitability of a business. Stock valuation should not be confused with business valuation.

The Importance of Stock Valuation in Trading

Stock valuation is important for the following reasons:

1. Stock valuation helps in predicting future market prices and the potential profit from the expected price movement. Through this, the stocks that are undervalued, are bought. The stocks that are overvalued, are sold. We will learn about the reason for selling overvalued and buying undervalued stocks in the next section. 
2. Stock valuation helps in determining if a stock is undervalued or overvalued relative to its potential. This is especially beneficial for investors. Through valuation, investors can compare the stocks within an industry. Investors can even identify the future prospects of the company. This can be extremely helpful. For investors, this is helpful since they can estimate the returns that investors will get from buying the stock at the current price. 

Stock Valuation Strategies for Beginners

For beginners, it is very important to not get too impulsive while valuing stocks. They should start their journey of valuing stocks by first understanding the fundamentals. Further, here is a step-by-step journey for beginners.

1. Understand the Importance: It is very important to understand why stocks are valued. Along with that, they should be theoritically aware of stock valuation.
2. Understand the company: You need to understand the financial characteristics of the company such as the dividend payment patterns or the cash flow predictability.
3. Identifying right valuation method: Once you have understood the company, it is crucial to identify the stock valuation method that fits the company. Does the company pay dividend or not? Does it have free cash flow or not? All these questions help in selecting the right stock valuation method.
4. Industry Norms: It is important to consider industry norms while choosing a valuation method for stocks. This is helpful since different industries work differently.

How is the Stock Valued?

There are multiple ways to value a stock. First, we need to ask questions. These questions will help us understand the financial position of the company. Let us take a look at some of the important questions for better share valuation:

1. How is the company making money?
2. Are the products and services of the company in demand and what is the reason?
3. What is the company's performance history?
4. Is the company positioned for profitability and growth?
5. What is the amount of debt on the company?
6. What is the current situation of the company's industry?
7. What are the challenges that are being faced by the company?
8. Are there any political, economic, religious or cultural risks that the company might face?  

While these are important questions to be asked before planning stock valuation, let us now learn about the different methods of stock valuation.

Methods of Stock Valuation

The following methods are used for stock valuation:

1. Price-to-Earnings (P/E) Ratio

The ratio price to earnings means evaluation of current stock price of company relative to its per-share earnings. Higher ratio of price to earnings means that the company will grow faster than its competitors has a high P/E ratio. This ratio is calculated by dividing the market value price per share by the company's earnings per share. It is used for determining the market value of stock and future earnings growth. A higher P/E ratio shows that investors want to pay higher share prices at present due to the growth expectations in future. It also means that the stock's price is high compared to earnings and is possibly overvalued. A low ratio of price to earnings means that the current stock price is low as compared to the earnings.

The market price of the share of a company is Rs 1000. In this case, the earnings per share is Rs. 10 which means that the P/E ratio will be 10. This means that investors have to pay rupees 10 for every rupee of the company's earnings.  

2. Dividend Discount Model

The dividend discount model or DDM is a quantitative method for predicting a company's stock price. It is based on the theory that the present-day price is worth the sum of future dividend payments when they are discounted back to the present value. The aim is to calculate the fair value of stock regardless of the market conditions. 

If the value obtained from DDM is higher than the current trading price of shares, the stock is undervalued and should be bought. In case the value obtained from DDM is lower than the current trading price of shares, the stock is overvalued and should be sold.

Here:

Intrinsic Value Per Share = D1 ÷ (ke – g)

D1 denotes the expected dividend for the next year

ke represents the cost of equity

g represents the dividend growth rate

3. Discounted Cash Flow Model

Discounted cash flow is a method used in the valuation of stocks. It is used for estimating the value of investments based on the expected cash flow in future. It determines the value of the investment today based on the projections of money that the investment will generate in future. This stock valuation method helps in determining whether an investor should buy the stocks of the company. 

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Let us say that the current stock price is $50. The expected future cash flow per share for the three following years will be as mentioned below:

Year 1: $5

Year 2: $7

Year 3: $10

The discount rate is 10%.

Let us now calculate the present value for each cash flow. Here, Present Value (PV) = Future Cash Flow / (1 + Discount Rate)^Year. 

As per this formula, the present value will be:

Year 1 PV = $4.55

Year 2 PV = $5.92

Year 3 PV = $7.51

The sum of all future cash flows will be:

Total Present Value (TPV) =  $4.55 + $5.92 + $7.51 = $17.98

According to the formula:

• TPV > Current Price, the stock is undervalued
• TPV < Current Price, the stock is overvalued
• TPV = Current Price, the stock is fairly valued

Let us now compare the current value with the total present value. As it is evident, the total present value is less than the current price. This indicates that the stock is overvalued based on the future cash flows and the chosen discount rate.

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How to Choose the Appropriate Stock Valuation Method?

Since every stock is different, finding the most appropriate method is not so easy. Every stock valuation method has its own advantages and disadvantages. Some industries with unique characteristics will require multiple valuation methods. 

Multiple approaches will be adopted to make comparative evaluations of the company's value in the market against competitors. While choosing a valuation method, ensure that it is appropriate for the firm that you are analysing. There are, however, two categories of valuation methods: absolute valuation and relative valuation. 

1. Absolute Valuation Models

These stock valuation methods try to find the intrinsic value of the investment based purely on the fundamentals. This means that the focus will be strictly on the cash flow, growth rate and dividends. Dividend discount model, residual income model, asset-based model and discounted cash flow model are the different types of absolute valuation models.

2. Relative Valuation

These models compare companies. It involves the calculation of ratios and multiples including price-to-earning ratios with multiples of similar companies. These models are relatively easy and quick to calculate compared to the absolute valuation model. Most investors and analysts start the analysis using this model.

Factors Influencing Stock Valuation

Stock valuation is influenced by several factors including the following:

• Performance: One of the important factors that influence stock valuation is how the company is performing. If the company is doing well then the stock valuation will go up since the stock will be worth more.
• Economic and market situation: Another reason that impacts stock valuation is the situation of economy and stock market. If the economy and the stock market is doing well, traders will have more confidence to invest in stocks. This will lead to an increase in the stock prices. Hence, it will lead to high stock valuation.
• Earnings and profitability: Investors are also influenced by the amount of profit the company is making and the future earnings potential. Higher profits will make the stock more valuable.
• Supply and demand: It is an important factor that influences stock valuation. If there is more demand for a particular share but the quantity of those shares are not enough, then the price of the stock will increase.
• News: Positive or negative news about a company has a strong influence on the price of the stock. If the news favours the company, then the stock price will go up. If the news is bad for the company, then the stock price will go down. 
• Investor sentiment: One of the factors that impact the valuation of a stock is investor sentiment. If the traders are optimistic about buying stocks of a company, it will push the price up. In case, people are not feeling positive about a stock, the price of the stock will go down.
• Industry trends: If an industry is growing, its valuation will be generally higher along with the P/E ratio. This happens because investors see the potential for higher future growth. In case, the industry sees declining demand, then the valuation of stocks will go down since investors do not see future growth. There is a high chance of stock devaluation in case of industries outranked by the new industries. New regulations within the industry also impact stock valuation.

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Common Mistakes to Avoid in Stock Valuation

The following mistakes must be avoided in stock valuation:

1. Using a single valuation method: Many investors use a single valuation method for companies with different characteristics. To prevent subjectivity while determining the valuation of a stock, multiple valuation methods can come in handy. Through multiple valuation methods, one can see the value distribution which is closer to the intrinsic value of the stock. 
2. Do not use the wrong valuation method: First, we need to identify the characteristics of the company for which you want to do the analysis. Once you have identified the characteristics, you will identify the appropriate valuation method to be used. Let's say that you have to calculate the intrinsic value of the company using DDM. But this company does not have any free cash flow. Since DDM takes free cash flow in consideration or if it does not pay any dividend, then avoid using this method. In case the cash flow is negative, you do not use DCF model.
3. Avoid over-optimistic assumptions: If an investor uses over-optimistic assumptions to calculate the intrinsic value of stock, it will result in calculations that are high and biased. In case, the assumption is conservative, the stock will reach its intrinsic value but the stock will be far below the intrinsic value. In case investors assume that the company will keep on growing, it will disrupt the calculation of intrinsic value.
4. Emotional investing: This is a barrier to accurate stock valuation. Due to emotional reactions, there is a high chance that the investor might make an impulsive decision. This may result in panic selling when the stock price goes down during market fluctuation or in greedy buying when the market goes up.

Pros and Cons of Different Stock Valuation Methods

Different stock valuation methods have the following pros and cons:

1. Price-to-Earnings (P/E) Ratio

Pros:

1. Simplicity: This valuation method is easier to calculate and can be easily understood.
2. Comparability: It helps in comparing different companies within the same industry.
3. Indicator of Market sentiment: It reflects what the market can pay for the earnings of a company.

Cons:

1. Manipulation of earnings: Companies can manipulate earnings through different accounting practices that affect the P/E ratio.
2. Not for companies with negative earnings: This method of stock valuation is not suitable for companies that are not profitable.
3. No account of future growth prospects: This valuation method does not take future growth prospects into account until they are in conjunction with growth rates. 

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2. Discounted Cash Flow (DCF) Analysis

Pros:

1. Consideration of Future: This method of stock valuation considers both historical performance and future potential.
2. Flexibility: This method allows adjustments based on the expected discount rates, growth rates and future cash flow projections.
3. Future cash flow: DCF method focuses on the future cash flows of the company. It is grounded in company's fundamental financial performance.

Cons:

1. Assumption sensitive: Any change in input assumption will lead to significant variations in valuations. 
2. Difficult Future Cash Flow Prediction: It is difficult to predict future cash flow for companies that do not have predictable cash flow.
3. Time-consuming: This is a time-consuming stock valuation method since it requires detailed financial modelling and assumptions related to future performance.

3. Dividend Discount Model

Pros:

1. Dividend Focused: This valuation method is suitable for the valuing companies that pay dividends on a regular basis.
2. Simple: It is a simple valuation model that involves straightforward calculations for companies with stable dividend policies.
3. Income-oriented valuation: This model is more appealing to those investors who focus on dividend income.

Cons: 

1. Not for Companies Without Dividends: This method is not suitable for companies that do not pay dividends. 
2. Ignore Non-Dividend Financial Performance: This method does not consider the complete financial health of the company except dividends.
3. Dividend growth rate dependent: This valuation method is highly dependent on the estimated dividend growth rates.