The Simple Guide - How To Value a Stock?
An investor’s success is directly proportional to her/his most important skill - the ability to properly value a stock. Expertise in stock valuation enables investors to trade confidently, predict a company’s future growth and make stable increments in assets.
There are valuation methods that can help an investor understand the value of a stock. Some of these methods are somewhat easy to follow, while others are more in-depth and rather complex. We understand that when using these methods for the first time, it’s easy to get overwhelmed by the many valuation methods. This is why we will direct the following article to those who are new to investing.
The Two Types of Valuation Models
These models strive to determine the essential or “true” worth of an investment based on cash flow, dividends, and the growth rate for an individual business – and not including the same for other stocks of other companies in the market. Valuation models in this category include:
- Dividend discount model
- Discounted cash flow model
- Residual income model
- Asset-based model
Dividend Discount Model (DDM) This is perhaps the most basic absolute model. It calculates the “true” worth of a company depending on the dividends the company pays its shareholders. This describes the actual flow of cash going to the shareholder, thereby getting the current value will tell us how much the shares should be worth.
To start with this model, we ascertain if the company pays a dividend. After this, we try and understand whether the dividend is stable and predictable since it’s not enough for the company to just pay a dividend. If companies do pay stable dividends, it can mean they are well-developed, which is a good sign for us.
Discounted Cash Flow Model (DCF) In case a company does not pay dividends or if the dividend has an irregular pattern, we turn to the discounted cash flow model.
What is the benefit of this model? We can use this for companies that pay or don’t pay dividends. Here we anticipate for five to ten years, and then a terminal value is estimated to assess cash flows beyond the forecast period. For this, we check if the company has foreseeable and profitable cash flows. The key here is that we can identify and exclude many companies that are small and new with low cash flows because of higher capital expenditures.
The Comparables Model This will be our backup model. If we cannot successfully value a firm with the models above, we will try and find the price multiples of the stock. A price multiple is any ratio that takes the share price of a firm together with certain per-share financial metric for a summary of valuation. The share price is usually divided by a preferred per-share metric to make a ratio.
Price multiple = share price / per-share metric
This model is the other valuation model we will briefly look at. It works by putting the company we want to assess to other related companies. These techniques include calculating multiples and ratios, like price-to-earnings multiple, and equating them with the multiples of similar companies. For instance, if the P/E of a firm is lower than the P/E multiple of a similar firm, the original company might be deemed as undervalued. This model is more straightforward and faster to compute than the absolute models, which is why this is the preferred model for beginners.
Where do we find Stock information?
Although there are lots of websites and apps for stock information, we highly recommend Money Control for Indian users. It offers detailed financial information about companies, news, portfolio, watchlist and more in English, Hindi and Gujarati. Download Here.
The Principles of Valuation from Fisher and Graham
Philip Fisher the author of ‘Common Stocks and Uncommon Profits’ was a wall street wizard. Warren Buffet was so fascinated with the book that he met with Fisher privately to learn more about his strategies.
‘The Intelligent Investor’ by Benjamin Graham is arguably the most widely recognized investment book in the world. In 1969, Buffet told Forbes, “I’m 15 percent Fisher and 85 percent Benjamin Graham.”
The following are a few golden rules to use in stock valuation which are used to this day by smart investors.
- Nobody ever knows what the market will do, but we can profit by reacting intelligently to what it does do.
- Stocks have business valuations and market valuations. The first is what the company would be worth if it was liquidated, the second is the price the market has placed on the stock.
- We should know a stock’s margin of safety, which is a general feel for how much that stock can drop in price and still be a good investment. Central to determining a stock’s margin of safety is knowing the difference between its business valuation and market valuation.
- Buy stocks from companies that can grow sales and profits over the years at rates greater than their industry average.
- When assessing a company, look at the top. Check out the CEO's profile and his policies to see if the company has good management. A good management team is willing to sacrifice immediate profits for long-term gains and maintains integrity and honesty with shareholders.
- Profits must follow sales. Sales are irrelevant if they don’t produce a profit. You should know a company’s profit margins.
- Profits must be realized soon enough to be useful. You should look for positive cash flow and a healthy cash reserve so the company can meet obligations without borrowing. How to take advantage of this advice? Look for market news on this website, like Our Biweekly Market Watch or other sites like BloombergQuint, Reuters India Finance and Economic Times
- Buy stock in a company with the same scrutiny you’d exercise when buying the business itself. Buy within your circle of competence and thoroughly understand your investments.
What is a Good Portfolio?
To succeed in investing, it is best to concentrate on industries we already know. Fisher called this the ‘circle of competence’. Within that circle of competence, investors should conduct deep research and analysis. This kind of work may prove to be futile if you are a lone wolf. This is why we must use a focused portfolio. Such a portfolio has fewer companies under your observation, which means you have more focus and time on them, which in turn equates to more return.
A good resource to learn more about stock valuation is, ‘The Neatest Little Guide to Stock Market Investing’ by Jason Kelly.
Members of our Exclusive Investor’s Club can lend this book to read for free. Click here to Join for Free