How to value a stock? There are several ways to value a stock
When it comes to being an investor there is nothing more important than knowing how to value a stock. This is certainly the most important aspect of the whole investment process. All of the other steps can be completely meaningless if you fail to value a company appropriately.
No matter how much sector research you do, or how many of the financial statements you read, it all comes down to price. Defining a price to pay, is always deeply influenced by the valuation. Valuation is a science in itself, and it takes years before you can do it correctly.
There are several different approaches to valuation, and in the midst of the process, you are bound to make some costly mistakes. That is ok, it happens to the best of investors. Even the Oracle of Omaha has made some mistakes recently with Kraft and in the past. We all make mistakes in our judgments from time to time. The main difference here is that every mistake ends up costing you money and can severely hinder your performance and the ability to compound your portfolio.
When it comes to approaching valuation, it is important to understand that even if your valuation is right, it might take some time for the market to reflect that. Joel Greenblatt has a great quote regarding valuation that every investor should keep in mind.
“If you do good valuation work, the market will eventually agree with you.” - Joel Greenblatt
Investors should be aware that it might take years before the market actually agrees with you. Instead of seeing this as a disadvantage, it is actually an advantage as it allows you to add more shares at low valuations.
Methods to value a stock
There are several approaches on how to value a stock, and different valuation models you can use. Valuation is essentially analyzing a stock to try and calculate its future cash flows and discount them in the future.
The discount is based on the time value of money. Since $10 is worth more today than in one year, we need to discount the value of that future $10. That brings us to the first and most commonly used model, the discounted cash flow model.
Discounted cash flow model
The discounted cash flow formula allows us to discount future cash flows, at a rate of our choice. This is the most commonly used method of valuation, as it can give us the best accurate picture of what the company’s future cash flows will be like. When you build a model, you should go through the company’s financial statements and analyze its results over the last fiscal years.
Once you have done that, you can easily stipulate what kind of growth the company has seen across different metrics. Consider how revenues and profits have grown over the past, as well as its margins. A discounted cash flow model should encompass estimates for different metrics while assigning a growth rate. This way you can roughly estimate what the earnings growth will be like, and essentially how much cash flow the company will generate for you.
Consider the worst-case scenario
Keep in mind, you should adjust your model according to different outlooks. Let’s say a company is expected to grow revenues and earnings per share (EPS) at 10% every year.
Consider at least three scenarios, a positive outlook scenario where the company grows at 15% a year, and a worst-case scenario where revenues and earnings per share remain flat. It is always important to consider the worst-case scenario when investing, as it allows you to better understand the potential downside of such an investment.
Models can certainly be a very useful way to analyze companies and project their future stock prices. Although they can be an important step when analyzing stocks, they can often be completely useless. Let’s ponder for a second how the coronavirus pandemic has affected and deeply changed the world we live in.
There were countless analysts covering thousands of companies worldwide, with complex models that ended up being useless. Models are important, but the bottom line is that they are just projections, and sometimes fail. This is because our world changes at such a fast pace. Therefore it is nearly impossible to model all those changes.
One way to value certain stocks is to look at the stock market and try to compare similar companies. With this in mind you should look for companies that are present in the same sector, and with that in mind compare its balance sheets, market cap, and a few other metrics. Another way to compare stocks of similar companies is by looking at their price-to-earnings and price-to-book.
This can tell how the market is valuing a certain company over the other. Higher-quality companies will usually trade at a premium relative to their peers. Higher valuations can also signal higher growth expectations. A company whose earnings per share are expected to stay flat will undoubtedly trade at a much lower multiple than a stock with an expected growth rate in the double-digits.
When it comes to similar companies, it is important to thoroughly analyze their balance sheets, and financial statements so you can compare. You will often find companies that are undervalued relative to their peers, and that can be an interesting stock pick. Remember that basing your valuation method solely, by comparison, is not always the best method of valuation.
Valuation is driven by metrics
Some investors choose to analyze stocks solely based on metrics. They will go through the company’s financial statements and consider several ratios like its price-to-book, price-to-earnings, debt-to-equity, and dividend yield. Based on those metrics they can then assess whether the stock is overvalued or undervalued relative to its market price.
Although this can be useful, it is sometimes fruitless because it fails to see the whole picture. It can be a great way to find possible stock targets to further analyze.
If you base your investment decision solely based on metrics, it can backfire. Although the market is not entirely efficient, large mispricings are usually rare. If a stock is trading at an attractive price and has certain desirable metrics it is usually for a good reason. Another approach that works is to consider the stock solely based on its assets, and that is commonly referred to as an asset play.
The bottom line on how to value a stock
In investing there is no single recipe on how to value a stock - that you can use to make every investment. Every stock is different, and as such, it should be analyzed individually. So you can deeply understand each company you consider investing in. Every approach has certain disadvantages, but using several approaches to valuation can be the best way to fairly assess a company’s value.
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