Stock valuation can be a useful way to gauge the worth of an asset or company. But what is stock valuation, and how can you use it to make the most of your trading operations? Read on to find out the basics on stock valuation models, including the various different types and metrics.
What is stock valuation?
Put simply, valuation is the analytical process of determining the current or projected worth of an asset or a company.
There are many techniques used for doing a valuation, and analysts use metrics such as the effectiveness of a company’s management, the composition of its capital structure, the prospect of future earnings, and the market value of its assets to place a value on the company.
Stock valuation can be useful when trying to determine the fair value of a security, which is determined by what a buyer is willing to pay a seller, assuming both parties enter the transaction willingly. Analysts use stock valuations to determine whether a company or asset is overvalued or undervalued by the market, with the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value. In this way, stock valuation can go a long way to help traders make more informed trading decisions.
Fundamental analysis is often an important part of the stock valuation process. If you want to find out more about fundamental analysis, you can check out our blog post here, and our dedicated Fundamental Analysis section here.
Types of valuation model
Stock valuation methods can be sorted into two different models, focusing on different metrics of analysis:
- Absolute valuation models, which attempt to find the intrinsic or “true” value of an investment based only on fundamentals. Fundamentals are factors such as dividends, cash flow, and the growth rate for a single company, and analysts who use these models focus on these factors without worrying about any other companies.
- Relative valuation models, which operate by comparing the company in question to other similar companies. These methods involve calculating multiples and ratios, such as the price-to-earnings multiple, and comparing them to the multiples and ratios of similar companies. These models are typically a lot easier and quicker to calculate than absolute valuation models, and many investors and analysts begin their analysis with this model.
Examples of absolute variation models include:
- The asset-based model, which focuses on a company’s net asset value; this is identified by subtracting total liabilities from total assets.
- The dividend discount model (DDM), which calculates the “true” value of a company based on the dividends it pays to its shareholders. This model is one of the most basic, and looks at the stability and predictability of dividend payments.
- The discounted cash flow model (DCF), which uses a company’s discounted future cash flows to value the business. This model can be used with a wide variety of firms that don’t pay dividends, and even for companies that do pay dividends, including irregular dividends.
- The residual income model, which is based on the idea that the value of a company’s stock equals the present value of future residual incomes, discounted at the appropriate cost of equity.
Relative valuation models can make use of a number of ratios and multiples, including:
- The price-earnings ratio (P/E ratio), which relates a company’s share price to its EPS, calculated by dividing the market value per share by the EPS, and can be used to determine the relative value of the company’s shares.
- The operating profit margin, which compares the amount a company earns before interest and taxes on sales are calculated, and can be a useful indicator of profitability and efficiency. To calculate this margin, you divide the operating income by the revenue and multiply that figure by 100.
- The price to book ratio (P/B ratio), which is calculated by dividing the market price by share by the book value per share, and reveals the market’s valuation of the company in relation to its intrinsic value.