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What is Valuation And How to Use it to Pick Stocks

Introduction

Valuation is the process of estimating a stock's intrinsic or true value. The computation relies on the stock's fundamentals, such as earnings, dividends, cash flows, growth rates, and assets. Valuation helps you determine whether a stock is under or overvalued at its current market price, thus identifying potential opportunities for buying or selling.

There are two primary valuation methods categories: absolute and relative. The former tries to find the value of a stock based on its characteristics. On the other hand, relative valuation methods compare one stock to other similar stocks in the market.

Let’s discuss some of the most common valuation methods and how to use them to pick stocks.

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1. Absolute Valuation Methods

Dividend Discount Model (DDM)

This method assumes that a stock's value equals its future dividends' present value. 

Formula—-

P0 = (D1) ÷ (r–g)

where 

“P0” is the current stock price

“D1” is the expected dividend per share in the next year

“r” is the required rate of return

“g” is the constant growth rate of dividends

The DDM is suitable for valuing stocks that pay regular and predictable dividends, such as mature and stable companies. However, it has some limitations, such as:

  • It does not account for the earnings or cash flows of the company that are not distributed as dividends.
  • It assumes that the growth rate of dividends is constant and less than the required rate of return, which may not be realistic for some companies.
  • It is sensitive to the inputs of dividends, growth rate, and required rate of return, which may be difficult to estimate accurately.

Discounted Cash Flow Model (DCF)

DCF assumes that the value of a stock equals the present value of its future free cash flows. Free cash flow (FCF) is the cash flow that is available to the shareholders after paying for operating expenses, taxes, and capital expenditures. 

Formula—

P0  = ∑nt=1  [FCFt ÷ (1+r)t] + [TV ÷ (1+r)t]

 Where

“r” is the weighted average cost of capital 

“n” is the forecast period 

“TV” is the terminal value.

The DCF is suitable for valuing stocks with positive and growing free cash flows, such as growth companies. However, it also has some limitations, such as:

  • It requires forecasting the future free cash flows for a long period, which may involve a lot of uncertainty and assumptions.
  • It depends on estimating WACC and terminal values, which may be subjective and sensitive to changes.
  • It may not capture the value of intangible assets or synergies on the cash flow statement.

2. Relative Valuation Methods

Price-to-Earnings Ratio (P/E)

The P/E computes how much investors are ready to pay for each unit of earnings. A higher P/E indicates that investors expect higher earnings growth or lower risk from the company. You can use it to compare stocks within the same industry or sector. A stock with a lower P/E than its peers may be considered undervalued, while a stock with a higher P/E may be considered overvalued. 

Formula—

P/E = P0 ÷ EPS

Where 

EPS is the earnings per share in the last 12 months.

The P/E approach has some drawbacks:

  • It disregards the quality or sustainability of earnings, which may be affected by accounting policies or one-time items.
  • It does not account for the company's capital structure or debt level, which may affect its risk and profitability.
  • It does not consider the company's growth rate or dividend policy, which may affect its future earnings potential.

Price-to-Book Ratio (P/B)

It compares the stock price to its book value per share (BVPS). The P/B measures how much investors are ready to pay for each equity unit. A higher P/B indicates that investors expect higher returns or lower risk from the company. You can use it to compare stocks with similar asset characteristics or business models, such as financial or utility companies. A stock with a lower P/B than its peers may be considered undervalued. 

Formula—

P/B =  P0 ÷ BVPS

Limitations of PB ratio

  • It disregards the assets' market value or earning power, which may differ from their book value.
  • It avoids the intangible assets or goodwill of the company, which may not be reflected in the book value.
  • It does not consider the growth rate or profitability of the company, which may affect its future equity value.

Conclusion

Valuation is essential for investors who want to beat the market and find undervalued or overvalued stocks. There are various methods of valuation, each with its own strengths and weaknesses. As an investor, you should use multiple methods to cross-check their results and avoid biases. You must also understand the assumptions and limitations of each method and adjust them according to the specific characteristics of each company and industry.

 

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