Stock valuation is the cultivated science of finding out the worth of a business. This is about cutting through what the hype says. Here’s what you get is the real, tangible value. Without any biases. Have you ever thought why some investors have the uncanny sense of finding the right companies? Well, the secret is mostly found in the way a company is valuable.
On the other hand, if you think valuation is only about calculating numbers, you are wrong. Stock valuation has to deal with numbers, but simultaneously it is also about understanding the growth story of a business beyond the numbers. While evaluating a business, we need to put numbers into context and see the bigger picture corresponding to the potential growth drivers.
Here in this blog we are going to break down this process.
How Valuation is Approached by Stock Market Experts
Suppose in an auction someone is selling a faint old painting. The seller already claimed it to be a hidden masterpiece and associated it with some artistic traditions and so on. But as a buyer you are skeptical and naturally you don’t take their word for it. For evaluating their claims you can check for painter’s signatures, do extensive background research about the artist, or call your one of your art aficionado friends who has a mastery of old paintings. This is how evaluating a stock goes. By using different tools you try to avoid overpriced stocks and find the underrated gems.
Here’s how it really matters.
- Valuation, first of all, keeps the FOMO in check. When most investors are going behind a latest stock, through valuation you can ask important questions and find out whether the stock actually worths it.
- Through valuation you also ensure peace of mind. When you evaluate and make sure you don’t overpay for a stock, it actually helps you keep cool even during the market crashes.
- The market is often full of bad noise that signals you to buy wrong stocks. Messy earning reports or auditory lapses are often common to put the wrong value for a stock. This is where valuation helps to cut through the noise.
Valuation always helps you to filter the right signal even from the loud noise. Remember that no valuation method is completely perfect and it is often like predicting the weather. Just as in weather prediction, use of radar historical data, and satellite images helps you come closer to right prediction but at times beyond all calculation you get rains, same happens with stock valuation.
Understanding the Building Blocks of Stock Value
As we have already said, stock’s value is not just about calculating figures and doing the math. In valuation we go beyond the numbers and find the stories, trends, contexts and human behavior. Here are the building blocks of a stock’s value.
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The Profit Factor
Companies go all out to make money and hence how and to what extent they make profits is a key consideration. Any business that incessantly generates profit irrespective of any situation, is the most reliable. There are also companies that insist on reinvesting profits instead of immediate payouts to ensure future dominance.
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The Narrative Behind A Brand
Investors always want to put their money behind a brand that has a convincing story to tell. For example, if a biotech startup promises to bring a potential cancer cure or a tech firm claiming to offer a new image generation app that works with simple prompts, can grab the attention of the investors easily. Such narratives often add to the valuations even before the company starts earning profits. But we also need to remember that such narratives can also turn into fairy tales.
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The Industry Trend
Considering overall industry trend is also a key component. For example, oil stocks rise high during energy crises and retail stocks shoot high when e-commerce sector is booming. So during valuation you need to ask whether the industry is thriving, dying, in neutral condition.
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Interest Rate
Interest rate offered by banks can also make an impact on the valuation of the stock at a particular time. For example, if a bank offers 5% on savings accounts, this can lead investors to demand higher returns from stocks. This can pull down prices of the stocks. In contrast when interest rates are cut, stock prices are likely to get a boost.
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Public Mood
Frenzy of the public for a particular product is common and often contributes to the unprecedented rise of some stocks. Often traditional valuation methods miss this component. This is why judging public mood and spotting popular frenzy around some products is crucial for valuation.
Absolute Valuation of Finding Intrinsic Value of a Stock
Absolute valuation is all about knowing the intrinsic value of a stock. Consider it like evaluating before buying a house. You need to assess the property’s foundation, location, and future potential. It is far from just comparing the property with that of the neighbors.
Discounted Cash Flow (DCF) is the most important tool for absolute valuation. DCF wants to inquire the a, pint of cash a company can generate over its lifetime. By that measure it also finds out what is the worth of that today. This valuation is technique is mostly used by mature companies with steady cash flows and companies from industries like utilities and consumer goods that follow mostly predictable trends.
Dividend Discount Model (DDM) is another tool for absolute valuation. As an investor if you always look forward to getting your quarterly dividend checks, this is the right method for you. This method values a stock based on the present value of all future dividends. Blue-chip stocks that always pay consistent dividends are best cases for this tool.
Relative Valuation or Comparing Stocks
Relative valuation that relies more on comparing stocks is more like shopping for a used car. For example, you are less likely to pay $10,000 for a 2010 Honda Civic without checking what other Civics sell for. This is how stocks are measured against their peers.
P/E Ratio is the most used tool for this valuation that tells you how much investors pay for $1 of earnings. Consider past earnings and forecasted earnings for the companies.
PEG Ratio factors growth into the earning measures used to evaluate a company. It is more appropriate for high-growth sectors such as tech and renewable energy. You should always avoid overhyped stocks with crazy P/E figures.
Price-to-Book (P/B) or Book Value of Stocks
P/B is about comparing the price of a stock to its book value or the value we get by deducting liabilities from assets. minus liabilities. It is ideal for evaluating value stocks such as banks, insurance companies, and asset-heavy firms such as steel and real estate.
Last Words
Let’s note that seasoned investors don’t just rely on one model. They have a mixed approach to use multiple models. They begin by using DCF to estimate the intrinsic value and then cross-check the same with P/E and PEG against industry peers. They also ask several questions and inquire whether the growth is sustainable, whether margins are eroding or increasing, etc.
