What is Stock Valuation?
Stock valuation is the method of calculating the theoretical values of companies and their stocks using their fundamentals and the current market dynamics. It is an important tool that helps us in making informed decisions about trading. This technique helps us estimate the current worth of an asset or a company.
There are two main ways to value stocks: Absolute and Relative valuation.
- Absolute valuation is a method to calculate the present worth of a business by forecasting the future income streams. Investors can determine if currently, a stock is under or overvalued by comparing it to the current price.
- Relative valuation is a method that compares a stock value to that of its competitors within the same industry to assess its worth. It is a very useful and effective tool in valuing an asset.
Methods Used under Absolute Valuation:
- Discounted Cash Flow Model
The discounted Cash Flow model is one of the best ways to determine the intrinsic value of a company or stock. Under this model’s approach, the intrinsic value of the stock is calculated by discounting the future predicted company’s cash flows to its present value. Using cash flow as a factor to estimate a company’s value is a better way to go than earnings, as earnings have the ability to be adjusted where cash flows are the cash left over for reinvestment or returning value to investors.
This model attempts to figure out the value of an investment today, based on the projections of how much money it will generate in the future. For example, the value of $100 in the future will be less than what it is today because inflation causes money to lose value in the future.
The only disadvantage of this model is that the factors used in projecting the cash flows like growth rate, required return of equity, etc are assumptions that might not be accurate. A lot of research goes into finalizing these assumptions and if the research is correct and comprehensive then so will be the results.
- Dividend Discount Model
The Dividend Discount Model is one of the basic techniques of absolute stock valuation. It calculates the true value of the asset or the company by assessing its dividend payout to the shareholders. According to this model, the dividend is the representation of the actual cash flow of the company.
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A company offers goods or services to earn profits. The cash flow earned from these business activities decides its profits, which gets reflected in the stock price of the company. These companies also make dividend payments to the stockholders, which usually comes from business profits. This model is based on the theory that the value of the company is the present worth of the sum of all its dividend payments of the future.
- Comparable Companies Analysis
This analysis is an example of relative stock valuation. Rather than determining the intrinsic value of a stock using the fundamentals of the company, the comparable model approach aims to derive a stock’s theoretical price using the price of multiple similar companies. It operates under the assumptions that similar companies should trade at similar multiples, all other things being equal.
This analysis starts with establishing a group or list of similar companies of similar size in the same industry. One can then compare a particular company to its competitors on a relative basis. Comparable analysis should provide a reasonable valuation range, while other valuation models such as the DiscountedCash Flow model are dependent upon a varied number of assumptions.
If someone intends to invest in the stock market, they can make use of ratios and different methods to evaluate the value of a stock. However, these valuation models explained above are not the only tools to conduct trade, though they are one of the best ones out there, and one should consider other parameters such as the trend lines and the history of the company you are wanting to invest in. It is also prudent to conduct your own research and analysis to obtain a clear view of the market.