Your goal as a stock trader is to find the best stocks to invest in, but the problem is that it’s not always so easy. There are many ways one can analyze the market in search of potential and value, and one of the more common ways is what’s called valuation methods. However, valuation methods is a very broad subject and there are many different methods one can use, from simple basic ideas to integrated valuation processes. Therefore we thought we’d walk you through the most common valuation methods used today.
Hopefully, at the end of this guide, you will have a greater understanding of how one can find value in the market and good stocks to invest in.
Up until very recently, valuation methods and these types of analytic tactics were “exclusively for professional investors” due to their level of difficulty and the need to understand the market. But we want to clarify that none of the methods we’re going to explain are very difficult and this is something that anyone with a basic mathematical understanding can make use of.
As mentioned, we’ll dive straight into the relative valuation models. These analytic methods are something we’ve discussed quite often before since it’s one of the most basic ways to analyze the stock market. Generally speaking, these methods are easier to understand than the absolute methods, which is why most investors get started with the relative valuation.
The idea behind a relative valuation is that you compare one company’s stocks with another similar company’s stocks to try and figure out which one has the best value. To do so, you focus on calculating ratios and multiples that you use as the point of comparison.
Using Financial Ratios for Relative Valuation
The most fundamental ratios that one can use for a relative valuation is earnings per share (EPS), and the concept is that you calculate how much profit a company makes on a per-stock-level.
- The EPS can be used to calculate other financial ratios to make the comparison more detailed and accurate. The following ratios are the most commonly used.
- PE Ratio (price/earnings ratio) is the most popular and simple of the financial ratios. You calculate the PE ratio by dividing the stock price with the earnings per share. The sum is a good way to compare two different companies within the same industry.
- PEG Ratio (Price/earnings and growth rate) is a continued calculation of the PE ratio where you also consider the company’s growth rate. This way you get a more detailed picture of how two companies performed compared to each other.
- Book Value is another super basic ratio that doesn’t require any calculating from your side. The book value is the valuation that the company is officially making and that they have reported to the government. The book value is easy to get your hands on directly from the company.
There are a wide array of other ratios one can use to compare the value of two companies, and we suggest you check out our guide on financial ratios to learn more. Now we’ll move on to the more accurate and popular valuation methods that are often used by the most successful investors.
Unlike relative valuations, absolute valuation methods focus on true and absolute values in a company. For example, a PE ratio can be calculated only using projections of how a company will perform, while absolute valuation methods are done using exact and known numbers. These numbers range from dividend rates, cash-flow, and assets. Let us explain by walking you through a couple of examples.
Dividend Discount Model (DDM)
The dividend discount model is used to estimate the value of a company and its shares by focusing only on the dividend they pay shareholders. Naturally, this method only works for companies that are paying a dividend so if the company you’re interested in doesn’t pay a dividend you can move on to the other methods. Traditionally, only well-established, blue-chip stocks pay dividends.
In order to complete the dividend discount calculation, you will compare the companies earnings per share with the dividend to find out if the dividend is stable and predictable, meaning that you can expect the company to pay an increasing amount in the future.
If that’s the case, you can assume that the company is a good investment. You can also use the data from past years to calculate how much you can expect to be paid in dividends on a yearly basis.
Discounted Cash-Flow Model (DCF)
When evaluating companies that don’t pay a dividend, the discounted cash-flow model is better. However, the DCF model can be used for any company whether they pay dividends or not.
This method is a great way to estimate how a company is set to perform in the future by focusing on the company’s cash flow. The idea is to compare a company’s operating cash flow, minus expenditures, to see how much free cash flow a company has. Essentially, the more free cash flow a company has the better it is. On the other hand, companies that have negative cash flow should be avoided since it’s hard to tell whether or not that company will do better in the future.
When using the DCF model the goal is to find companies that have stable and predictable free cash flow rates for the coming 5 to 10 years. Generally speaking, this only applies to well-established companies since new companies tend to invest a lot of their cash flow back into the company in order to grow further.
Other Methods Used for Stock Valuation
In addition to all the above-mentioned relative and absolute methods, there are other ways one can calculate the valuation of a company stock. For example, the Return on Invested Capital (ROIC) which measures how much a company makes each year per invested dollar, and the PS ratio, which is a comparison between how much a stock costs and the company’s annual sales.
Summary of Valuation Methods for Stock Investors
Anyone looking to buy shares in a company needs to be able to find the best stock that has the potential to pay the most profits over time. There are many ways one can compare two companies in order to figure out which one is a better investment and these methods are often referred to as valuation methods.
Valuation methods can be divided into either relative valuations that focus on ratios such as PE, EPS, and PS, or absolute methods which are calculations based on a company’s cash flow, ability to pay dividends, and more.
The problem with valuation methods is that there is not one method that’s better than all others and depending on the situation certain models provide a better projection. Because of this, we suggest you try to learn as many methods as possible so that you can adapt your stock valuation processes depending on the situation.