What is Stock Valuation?

In simple words, stock valuation is a tool to calculate the current price, or value, of a company. It is used to not only calculate the value of the company but help an investor decide if they want to buy, sell or hold a company's stocks.

Valuation of stocks is an important part of investing and is used by investors all over the world. There are several formulas to find the valuation of stocks and two major methods of finding the stock valuation.

What is a stock?

Before we delve deeper into the topic, we should have a basic understanding of what stock is. A stock is a part of a company. A person can buy stock in a company and become a part-owner of that company. Buying stocks is considered an investment.

Cash Flows for Stockholders

The value of a stock can be calculated by calculating the expected future cash flows associated with the stock. The investor can earn either earn through:

• Dividend paid to him by the company, or
• By selling the stocks based on the valuation of the company in securities markets, often referred to as stock exchanges, as capital gains.

What are the methods of Stock Valuation?

There are two basic methods of Stock Valuation, mainly:

1. Absolute method

2. Relative method

Absolute Method

The absolute method is dependent on finding the intrinsic value of the stock. The true value of a stock is known as intrinsic value. The intrinsic value of the stock can be calculated with the help of the following methods:

Dividend Discount Model (DDM): In this method, the company's current stock price is calculated using the theory that the present value of the stocks is worth the sum of all of its payments of future dividends when discounted back to their present value.

Value of Stock = (CCE−DGR)/(EDPS) ​

where: EDPS = expected dividend per share 

CCE = cost of capital equity

DGR = dividend growth rate

Discounted Cash Flow Method (DCF): In this method, the company's current stock price is calculated based on expected future cash flow.

Relative Method

Under this method, the price of the asset is derived by comparing the stocks with similar assets. Simply, the value of the stock is calculated in relation to other similar assets. There are various valuation metrics or valuation ratios under the relative method that help in stock price calculation, they are:

Price-to-Earnings (P/E): Using the P/E ratio, we can find out how much an investor will willingly pay for each unit of the company's earnings. High P/E ratio means that the investor expects to earn substantially from the stock. It is also worth noting that stocks with a high P/E ratio are overvalued. Similarly, stocks with a low P/E ratio are undervalued. You can find out if a company is overvalued or undervalued just by comparing its P/E ratio.

P/E = Share Price / Earnings per share

PEG Ratio: If the ratio is greater than 1, it is considered overvalued. If it is less than 1, it is considered undervalued. If the PEG ratio is 1, it shows that the company's current value and projected value growth are perfectly correlated.

PEG Ratio = (P/E) / Earnings Growth Rate

Price-to-Sales Value: Low P/S value stocks are considered cheap than the stocks that have a higher P/S.

P/S Ratio = (Market Cap) / (Annual Sales)

Price-to-book Value: A less than 1 P/BV ratio shows that the investors see an overvalued company. If the P/BV ratio is high, then that means that the investors think that the company's assets are undervalued.

P/BV = (Market price per share) / (Book value per share)

Simplifying the Process of Valuation of Stocks

There are three ways that simplify the process of valuation of stocks by calculating future dividends:

 Zero Growth Method

In this special case, we assume that the dividend is constant, it does not change over the course of the company's existence. Preferred stock (a hybrid between equity and debt) is an example. Price is calculated using the perpetuity formula.

Price = (Dividend) / (Required Return)

Constant Dividend Growth Method or Gordon Growth Method (GGM): 

In this special case, the dividend by the firm increases at a constant percent every quarter or every year. 

The formula is P = D/(r-g), where P is the current price, D is the next dividend the company is to pay, g is the expected growth rate and r is what's called the required rate of return for the company.

Super Normal Growth Method:

In this special case, dividend growth is not initially consistent but settles down to constant growth eventually. The initial period is a high growth period where the investors earn high returns on their investment, eventually, the profit settles down to normal profit in the long run.

Market Value Method for Calculating Valuation of Stocks 

In the Market Value Method, the value of the stock is calculated by comparing prices of similar stocks in the market. It uses the recent sales of similar securities after adjustments as a measure of calculation of the value of Stocks. 

In markets like publicly traded shares, where there is an abundance of data available for calculating the price of the asset, Market Value Method can be employed. Unfortunately, this method cannot be used if the information available is incomplete. Other methods like Cost Approach or Discounted Cash Flow Analysis may be used in this case.

Common Mistakes

Here are some common mistakes that people generally make while calculating the valuation of stocks:

Confusing Net Income to be equal to Net Cash Flow:

Discounting net income instead of net cash flow can result in overvaluation. Discounting should be done on net cash flow because net income does not take into account the change in capital expenditure, net working capital, and interest-bearing debt.

There is no support to the long term growth rate:

The long-term growth rate generally should not exceed 5-6%. Long term growth rate is used in the income approach and drastically changes the result. A growth rate greater than 5-6% implies that the company will grow to be larger than the economy as a whole into perpetuity, generally, there is nothing to support this super-normal growth rate. This inflated growth rate can result in over-valuation. 

Context and Applications

The subject “Stock Valuation” is important for the professionals associated with Investment and Trading. The Topic is significant for students enrolled in: 

• MBA (Finance)
• Master in Commerce and Economics 
• Bachelors in Commerce and Economics 
• Bachelors in Business Administration

The topic "Stock Valuation" would help fellows who want to be part of investment firms, have a personal interest in investing and equity, or want to broaden their investment portfolio. 

Related Concepts

• Equity and Debt
• Stock Market and Trading
• Investing in Securities Market
• Valuation Models and Valuation Methods

Practice Problem

Question:

A dividend payment of $2.00 was made by ABC Company. The dividend is expected to increase by 3% per year. If the market requires a return of 14% on assets of the risk, how much should the stocks be selling for?

Solution: 

D₀ = $2.00

G = 3% or 0.03

R = 14% or 0.14

P₀ = [D₀ (1+G)] / (R-G)]

     = [2(1+0.03)] / (0.14 – 0.03)

P₀ = 18.73

Here, G = Growth Rate

D₀ = Current Dividend Payment

R = Required return

P₀ = The current price of the stock

Hence, the current price (P₀) of the stocks should be $18.73.