Best Stock Valuation Methods

Wouldn’t it be wonderful if just one foolproof formula existed to determine a stock’s underlying value?

Unfortunately, in the cut-throat world of high finance – where investors and analysts ceaselessly compete to outsmart the market – there is a bewildering array of procedures and techniques available to achieve that goal.

Whether using discounted cash flow analysis or comparing a company’s financial metrics, it is not always easy to tell if you are on the right path or just barking up the wrong tree.

However, by taking a methodical approach to this otherwise complex endeavor, you can quickly establish a system that demystifies the process, virtually guaranteeing a robust stock-picking mechanism that will last for years.

Source: Unsplash

Why Stock Valuation Is So Important

The intrinsic value of a business refers to its underlying worth, usually expressed in terms of fundamental markers such as earnings, assets, and cash flows.

However, this is only sometimes reflected in a company’s market price due to the principles of supply and demand.

For instance, when there are more buyers than sellers for a particular stock, the price increases beyond its fair value. Conversely, prices tend to decrease below their inherent value when there are more sellers than buyers for a specific security.

In this way, market prices can diverge based on fluctuations in investor sentiment and speculative activity that distort their correct valuations.

Moreover, market inefficiencies such as information asymmetry may also lead investors to undervalue or overvalue certain stocks despite their actual potential for growth.

Therefore, it is crucial to analyze not only financial ratios but also consider external factors when pricing securities since they both determine whether market prices correspond with the natural values of those companies or not.

In general, stock valuation methods are either classed as absolute or relative, depending on the techniques they apply. So, let’s take a closer look to see what they entail.

Absolute Valuation

While absolute valuation is a quantitative approach used to assess an asset’s intrinsic worth, it is not influenced by market trends, instead relying on fundamental analysis and financial metrics such as cash flows, dividends, and book value.

Indeed, the process involves determining the present value of future cash flows expected from a company. This requires making projections about performance based on historical trends and other factors relevant to the specific industry or venture under consideration.

The term “absolute” in this respect emphasizes that this protocol is independent of external factors and provides a more objective measure of true value.

Thus, this method can be used for a wide range of investment opportunities – including stocks, bonds, and real estate properties – but is only considered adequate when applied carefully with robust data inputs that account for potential market risks and uncertainties.

One of the most widely used tools in the absolute valuation kit bag is the Dividend Discount Model (DDM).

The DDM works by discounting the expected future dividends back to their present value using an appropriate discount rate.

The model assumes that investors buy stocks mainly for their potential income streams and seek higher returns as compensation for taking on additional risk.

Consequently, it significantly emphasizes the stability and growth prospects of a firm’s earnings and dividend payouts over time.

Relative Valuation

Relative valuation – sometimes known as the “comparables model” – is a financial methodology used to assess the value of a security by comparing it to equivalent assets in the same marketplace.

This concept primarily functions by assessing earnings and revenue multiples – such as the PE ratio and price-to-sales fraction – as well as profitability yields and enterprise values across similar companies within a given industry. The process aims to identify pricing discrepancies between analogous firms that could indicate trading opportunities with positive upside.

In fact, the reasoning behind the comparable approach is founded on the Law of One Price, which asserts that two identical entities should be traded for approximately equivalent prices. By using this method, you can gain a deeper comprehension of how diverse investment alternatives compare to one another within an industry.

Absolute Valuation: The Pros and Cons

The absolute valuation method presents many advantages for investors looking to prioritize long-term gains over short-term profits.

For example, this approach focuses on the intrinsic value of stocks, which reflects their genuine worth based on factors such as company performance, assets, and market position. By considering this measure instead of relying solely on current market prices or trends, absolute valuation offers a more accurate estimate of a stock’s growth potential and identifies undervalued options that may present good investment opportunities.

Furthermore, as this method is less concerned with extreme movements in the market, it enables investors to capitalize on favorable circumstances where stocks are trading under their intrinsic value while maintaining a comprehensive outlook for potential future earnings.

Nevertheless, while the absolute valuation technique may present a helpful framework for approximating a company’s worth, it is vital to acknowledge its limitations.

Undoubtedly, one of its significant drawbacks is the dependence on subjective assumptions and projections regarding forthcoming cash flows and growth rates, which are innately uncertain and prone to change over time.

Consequently, such substantial ambiguity can hinder investors’ ability to accurately predict a company’s future value, particularly in rapidly shifting market conditions where new information or events may influence investor sentiment.

Moreover, past financial data may not always indicate current market conditions or trends, resulting in possible information bias when using this approach.

Best Stock Valuation Methods: Relative or Not?

Using a relative valuation approach provides a basis for comparison, enabling investors to evaluate the worth of a security in correlation to its counterparts within the same industry.

This investment-oriented methodology is particularly advantageous when recognizing under-appreciated assets or those that may have an inflated value.

Relative indicators are also straightforward to comprehend and furnish a convenient way to scrutinize and appraise securities, especially when employing short-term trading tactics where prompt decisions must be made based on current data.

Likewise, comparative analysis with sector peers permits investors to gain valuable insights into contemporary market trends and conditions. Moreover, examining how a security measures up relative to others can provide essential nuances into the psychology of investor confidence, which can inform more strategic decision-making when interpreting such signals about future performance expectations.

That said, after conducting a relative valuation analysis, it’s prudent and instructive to acknowledge its deficiencies.

To begin with, this approach only offers a limited consideration of fundamental value as it’s primarily designed to compare similar companies within an industry or market sector. As such, it fails to capitalize on other valuable metrics such as brand recognition, patents, and technology leadership, which are unique company-specific factors that can influence a firm’s valuation significantly.

Secondly, relative valuation does not account for industry-specific analysis and overlooks several external economic factors affecting growth potential, leading to an incomplete interpretation of financial statements used in equity research.

Furthermore, it’s also vulnerable to market volatility and can produce unreliable results during times of high uncertainty or sudden changes in macroeconomic conditions – such as recessions or political instability.

Lastly, relative valuation requires investors to have no long-term perspective but instead adopt a short-term outlook, as most comparisons use current financial data provided by companies rather than forecasting their future prospects.

Wrap-up: 4 Stock Valuation Methods

Four stock valuation methods include discounted cash flow model, relative valuation, dividend discount model, and asset model

Selecting a promising stock is a complex matter involving several known and unknown elements.

Nonetheless, a crucial factor that must not be disregarded is the requirement to conduct extensive research into a company’s fiscal well-being while staying up-to-date with market developments.

This diligent investigation entails scrutinizing significant performance metrics like revenue expansion and profit margins to confirm if the company possesses a secure financial base.

However, it’s important to note that no formula guarantees success in stock picking – and even companies with solid fundamentals can face unforeseen challenges or disruptions to their operations.

As such, experienced traders tend to take a diversified approach to investing by incorporating both relative and absolute valuations where appropriate.

Effective stock picking requires a balance of informed decision-making grounded in data analysis while remaining responsive to evolving market conditions and dynamics within industries – an art and a science that, when meshed together, leads toward meaningful and sustainable profits.

---

The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.