Stock valuation refers to calculating the theoretical values of a company, together with its stocks. Basically, the purpose here is to predict potential market prices and to profit from the general price movement on the market. The stocks that are considered undervalued are bought, while the ones that are overvalued are sold, expecting that the first will rise in value, while the latter will decrease. Today we are going to have a look at various stock valuation methods and why you should do it.
Types of Valuation Models
There are two types of valuation models you can choose from: absolute and relative.
- Absolute valuation models – these try to find the intrinsic or the ‘true’ value of an investment, relying only on fundamentals (cash flow, dividends, growth rate, etc.) for just one company. Some examples are the residual income models, the dividend discount model, the discounted cash flow one, the asset-based models, etc.
- Relative valuation models – the relative valuation models aim to compare the company they are valuating to other similar companies. They imply calculating ratios or multiples (such as the price-to-earnings multiple) and then comparing them to the multiples of other companies that can be compared with the one in case. Usually, people prefer to approach these methods first because it’s easier and quicker.
Stock Valuation Methods
1. Dividend Discount Model (DDM)
This is one of the most basic stock valuation methods. It calculates the ‘real’ value of a firm depending on the dividends it pays to the shareholders. The reason for relying on the dividends to value a company is the fact that the dividends represent the actual cash flows that are going to the shareholder. As such, valuing the current value of the cash flows shows you how much the shares are worth. Naturally, the first thing to do is to see whether the company even pays a dividend and if it’s stable and predictable.
Usually, the companies that meet these conditions are blue-chip ones, found in mature and well-developed industries. Indeed, this is the best type of company to apply this valuation method.
2. Discounted Cash Flow Model (DCF)
But what happens if the company doesn’t pay a divided at all or its pattern is not regular? In that case, you can move on and check if the company wouldn’t fir the discounted cash flow method better. As such, instead of analyzing the dividends, this second method relies on using a company’s discounted future cash flows to valuate the business. The main good thing about this is the fact that it is useful for a variety of companies that don’t pay dividends.
There are many variations to this method, but the most common one is the two-stage model. With this, you forecast the free cash flows for 5 – 10 years, and then you calculate a terminal value to account for all the other flows beyond the forecasted period. As such, the first requirement for this is that the company has predictable free cash flows, and them to be positive. However, this means that you get to exclude plenty small high-growth firms and other non-mature firms, since they have large capital expenditures.
3. Comparables Method
Our third suggestion is to use this comparable method, which is a type of catch-all. This is a solution if you can’t use any other method to value the company or you don’t want to waste time doing the numbers. The comparables method doesn’t try to find the intrinsic value of the stock like the rest of the suggestions did. Instead, it simply compares the price multiples for the stock to a benchmark and then it sees whether that stock is under- or overvalued.
The reason for this method is relying on the Law of One Price. This states that any two similar assets should theoretically sell for the same prices. People like this method thanks to its intuitive nature. Moreover, they can use it in almost all circumstances because it has a vast number of multiples to be used:
- Price-to-earnings (P/E);
- Price-to-book (P/B);
- Price-to-sales (P/S);
- Price-to-cash-flow (P/CF), etc.
However, the P/E ratio is the most common one because it relies on the company’s earnings, so one of the primary drivers of an investment’s value.
Here you have a longer clip explaining in detail some of the valuation methods:
Why Should You Value Your Stocks?
There are many reasons for which business owners decide to choose one of the stock valuation methods we proposed above and not only. Let’s have a look at some of them:
1. To Understand the Business’ Worth
For one reason or another, many business owners, after getting their startup to success, want to know their business’ worth. Many entrepreneurs sell a business after they get it off the ground, so this is a helpful step along the way.
2. For Selling
Using one of the stock valuation methods we presented above is an essential step in evaluating an offer for the business. In this way, the owner can negotiate a strategic sale and end up with more profit.
3. To Justify the Per Share Equity Value
The annual shareholder meetings are a good opportunity to justify the per share equity value. This can also further help you with other financing possibilities, for example.
4. To Improve the Business
Evaluating the business helps you identify any weaknesses in a business. Thus, you can then move on and refocus all the operational efforts to make the entire business more profitable.This is often used together with inventory control to improve certain aspects of the company.
Naturally, there are plenty other reasons for which people decide to valuate their business, but these are some of the most common ones.
To sum it all up, there may be plenty of situations where you may need to valuate your business. Even if it sounds like a complicated process, the stock valuation methods can clear things up for you. They’re not hard to apply, but if you find any difficulty with them, you can always ask for professional help. Ideally, you should use and combine several methods to get the most accurate results.
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