If you want to start investing directly in stocks and shares, prepare to put some effort into researching the companies you’re interested in. As well as looking into the qualitative aspects of a company – such as how it’s managed and whether it has any compelling USPs – a bit of qualitative number crunching will enable you to put a value on the stock and check whether it fits with your investment strategy. Here’s how to get started.
What is stock valuation?
Stock valuation is the process of using analytical methods to calculate the intrinsic value of a stock. It’s a process that investors use to help them decide whether to buy a stock, depending on their investment goals.
There are several ways to value stocks, and the most appropriate method depends on the nature of the company you’re considering investing in. For example, more established companies with a proven track record of steady profits may require a different valuation method than new startups that haven’t yet made any profits.
Is a stock’s value the same as its market price?
It depends on your perspective. Strictly passive investors might argue that market price and stock value are almost always the same because all relevant information is priced into a stock. Therefore, they would typically be happy to mainly invest in index (or tracker) funds, which look to match rather than beat the performance of a stock market index, such as the FTSE 100.
However, others would argue that a stock’s intrinsic value may differ from its market price. This would particularly apply to active investors looking to choose investments that beat the performance of indices. They calculate a stock’s value using a set of metrics and may then compare this value to its market price (and potentially the value of other similar stocks) before deciding whether to buy (or sell).
What are the types of stock valuation?
There are 2 broad categories of stock valuation: absolute and relative.
What is absolute stock valuation?
This involves analysing the fundamental performance of a business on its own merits without comparing it with any other companies. Absolute valuation calculations focus on things such as dividends, cash flow and growth rate. Methods include the dividend discount model and discounted cash flow model.
What is relative stock valuation?
Relative stock valuation takes into account the performance of other companies. You carry out the same calculations for both the company you’re interested in and peer firms and use this comparison to assess whether the stocks you’re considering are worth it. There are relative stock valuation methods, including price-to-earnings, price-to-sale and price-to-book ratios.
What is the most common way to value a stock?
One of the most common ways to value a stock is through a company’s price-to-earnings (P/E) ratio. This is a variant of a relative valuation method. This is calculated by taking a firm’s stock price (total value of all a company’s outstanding shares) and dividing it by its most recently reported earnings per share (EPS). A company’s basic EPS should be reported in its financial reports. Alternatively, you can calculate it by working out a company’s net profit (net income with any dividend payments substracted) and dividing the figure by the number of outstanding shares.
The price-to-earnings ratio is commonly used to calculate stock value because it focuses on earnings, which is one of the key drivers of an investment’s value. However, it isn’t appropriate in all circumstances, not least because some newer companies won’t yet have earned anything.
What is a good price-to-earnings ratio for a stock?
That depends on your priorities and the investment strategy you’re following. A good price-to-earnings ratio (P/E ratio) for one investor may not hit the mark for another. For example, a growth investor might seek out stocks with a high P/E ratio on the basis that this indicates a high growth rate. Meanwhile, a value investor might prefer stocks with a low P/E ratio. This would typically imply that the market price is below the stock’s actual value and that the stock is, therefore, a bit of a bargain.
What other ways are there to value a stock?
Our summary below outlines some of the methods used to value stock. It’s not a comprehensive list of all possible methods, but it should give you a flavour of the key options available to you as a prospective investor.
Absolute valuation methods
The Dividend Discount Model (DDM). This calculates a firm’s value based on the dividends it pays shareholders and its expected future growth. The idea is that dividends represent the money being actually paid out, so they give a good indication of each share’s worth. However, this method obviously only works if the company pays its shareholders dividends – not all do. It’s also best used for companies that pay predictable dividends, such that the value doesn’t vary wildly from one dividend payment to another. This would tend to apply to well-established, blue-chip companies with a proven track record. There are a couple of formulae that can be used. One calculates a “rate of return” value and uses the following formula: (dividend payment / stock price) + dividend growth rate. The dividend growth rate is the average rate at which dividends increase each year.
Discounted cash flow model (DCF). With this method, a stock’s intrinsic value is calculated by discounting a company’s free cash flows to its present value. It doesn’t involve any assumptions about the distribution of dividends, so it can be used for companies with unpredictable dividend payouts or those that don’t pay dividends. As is often the case, there are several methods for calculating DCF-based value. One of the most common – the two-stage DCF model – involves first calculating the free cash flow forecast for 5 to 10 years, then measuring terminal value for all the cash flows beyond the forecasted period. This method is best suited for companies with positive and predictable free cash flows, so it probably won’t be right for companies still in their early growth phases.
Relative valuation methods
Variations on the price-to-earnings ratio method include:
Price-to-sales ratio. This is a company’s stock price divided by its annual revenue. It’s based on revenue rather than earnings, so it can be used for companies not yet making a profit. However, because sales volumes can vary greatly across industries, it’s best used to compare companies with similar business models.
Price-to-book ratio. With this method, a company’s stock price is divided by the company’s book value per share. A book value is its assets minus its liabilities (these can be found on a company’s balance sheets). To get the book value per share, divide the book value by the number of outstanding shares. Price-to-book ratios are sometimes used for asset-heavy businesses, such as banks.
What is the best measure of value for a stock?
You probably won’t be surprised to hear that there’s no overall “best” way of measuring a stock’s value. As our summaries of the different types above suggest, the best stock valuation method for one company may not be the best – or simply won’t work at all – for another. The key is getting to know a company’s characteristics and choosing the valuation method that suits it the best. If more than one could apply and you have the time and inclination, you could carry out several different calculations to get a range of possible values.
Well, if you’re investing with a view to “beating the market”, you probably should. And, let’s face it, if you’re investing directly in stocks and shares rather than in index funds – which aim to match rather than beat the performance of popular stock indices – then you probably are.
We’re sure you don’t need us to tell you there are no guarantees when it comes to investing. But taking a bit of time to learn how to value stocks before hitting the buy button, and putting those skills into practice, can help to make sure you choose stocks that are aligned with your investment strategy. And ultimately, sticking with your investment strategy means you’re more likely to meet your investing goals.
Is it difficult to value a stock?
How difficult it is to value a stock depends to a certain extent on the nature of the company, as some may be harder to value than others. You will need to decide the best method (or methods) to value a stock, dig out the metrics you need to do the required analysis and do a bit of maths according to the formula you’re using. A bit of leg work comes with the territory if you’re planning to invest directly in stocks, though, and there are tools available on the internet that can help. And, if worst comes to worst, you can pay a professional financial adviser to value stocks and make recommendations for you.
Bottom line
There are a number of ways to value a stock. The best method depends on the nature of the company, your investment strategy and whether an absolute or relative valuation is more appropriate. But taking the time to work out the best method (or methods) and dig out the metrics to do the analysis can help investors to decide whether a company is worth buying shares in.
Frequently asked questions
The best way to calculate the fair value of a stock depends on the type of company you’re considering buying stocks in. For example, well-established blue-chip firms with a proven track record will likely require a different valuation method than startups that are yet to profit. Look at some common methods outlined in this guide to help you decide.
A company’s price/earnings ratio assesses its current share price relative to its earnings per share. It’s one of the most popular ways to value a stock.
Ceri Stanaway is a researcher, writer and editor with more than 15 years’ experience, including a long stint at independent publisher Which?. She’s helped people find the best products and services, and avoid the pitfalls, across topics ranging from broadband to insurance. Outside of work, you can often find her sampling the fares in local cafes. See full bio
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