Using stock valuation methods to identify undervalued stocks can help traders and investors spot their next investment opportunity. Learn what stock valuation methods are and how the key methods compare to one another.
When a market analyst or financial commentator considers a stock to be “undervalued” and a “buy,” there is a good chance that they have used the discounted cash flow (DCF) stock valuation technique to arrive at that conclusion.
This is one of many stock valuation methods, all of which are designed to help you gain a better understanding of how stock prices work and help you try and maximize your investment returns.
What are stock valuation methods?
Stock valuation involves using the data associated with fundamental analysis to better understand a company’s current financial standing, as well as its prospects. Once you have established a company’s current and future worth, you can make an informed decision as to whether the stock market has priced the stock correctly, or if now is the time to buy or sell it.
Absolute valuation
The absolute valuation technique involves gathering crucial data about a firm, such as its earnings, debt levels, investment expenditure, and profit margins. This information can then be used to establish the company’s intrinsic value and to estimate a shareholder’s potential returns from the project in terms of capital gains and dividend income.
Relative valuation
Relative valuation models use similar metrics to those used in absolute valuation, although their primary focus is on evaluating a stock’s price in relation to the rest of the market. Comparisons are made with the metrics of similar stocks in the same sector, or with a broader market benchmark such as the S&P 500 Index.
Tip: Absolute valuation focuses on a company’s intrinsic value and stock price, whereas relative valuation considers the best, current investment options.
Discounted cash flow model (DCF)
The discounted cash flow model focuses on projected future earnings and the fact that a company shareholder is entitled to a share of its earnings. By calculating the potential value of this revenue over a period of time, investors can make an informed decision about purchasing a stock at its current market price.
This analysis will give you an idea of the stock’s fair market value and whether it appears to be priced correctly. The “discounted” aspect of the DCF model highlights the risks associated with the fact that investors are rewarded at a future date.
Tip: Because different investors use varying discount rates, different conclusions about a stock’s fair value are often reached.
Dividend discount model (DDM)
The dividend discount model focuses on dividend payments made to investors rather than on a firm’s revenue generated. At the discretion of a company’s management team, profits from business operations can be distributed to shareholders in the form of dividends.
However, the discretional aspect of dividends means that firms can also decide not to make these payments to investors, instead preferring to reinvest profits in new business development and/or future growth.
Comparable valuation models
Comparable valuation models involve compiling data from companies with similar characteristics for analysis. This approach employs various metrics, including:
- Enterprise value to sales (EV/S) – a financial ratio that measures how much it would cost to purchase a company’s value in terms of its sales
- Price to earnings (P/E) – the share price of a company divided by its earnings (net profit) per share (EPS)
- Price to book (P/B) – the ratio of the market value of a company’s shares (share price) over its book value of equity
Conducting a comparable analysis can help you to decide whether to invest in a specific sector, such as solar power or lithium battery technology, and create a shortlist of the most promising and best-value stocks within that sector.
Other valuation methods
There are many different methods of stock valuation, so it is important to consider the suitability of each method for a particular stock or sector. Growth stocks, defensive stocks and value stocks have different characteristics to one another, as do the healthcare, banking, and mining sectors. As a result, a broad range of other valuation methods have been developed.
Book value
The book value represents the value of shareholders’ equity in a business. It is derived from a company’s balance sheet statement and is calculated by subtracting the total liabilities of a company from its total assets.
Times-revenue
In the times-revenue valuation model, a multiplier is applied to revenue stream forecasts. The size of the multiplier is determined by the analyst and should take into account sector—or stock-specific factors as well as underlying macroeconomic themes.
For example, a growth-oriented tech stock, such as Nvidia, might have a multiplier of x3 applied to its valuation, while a healthcare giant, such as Johnson & Johnson, may have a multiplier of x0.75.
Liquidation value
The liquidation value represents the net cash that a business would receive if its assets were liquidated and all liabilities were settled today.
Tip: Most valuation methods have limited capacity for considering external factors such as interest rates or national employment levels.
How to use valuation methods as part of your investment strategy
A range of different valuation methods can inform the decision to buy or sell a stock. It is important to ensure that the metrics used to analyse the data are relevant and appropriate for the specific stock or sector under consideration. Having four indicators that confirm that a stock is a “buy” is a much stronger signal than having only one.
Final thoughts
Stock valuation methods play a crucial role in determining stock prices. They can be used to establish a stock’s fair value or compare a stock’s valuation to other, similar stocks. These metrics are used by a range of investors, from trillion-dollar pension funds to individual retail traders. Understanding the factors that analysts base their decisions on, and where they spend their money, can help you to trade in line with prevailing market trends.
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FAQs
- What are the risks of using absolute valuation methods?
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Knowing a stock’s intrinsic value through absolute analysis is useful, but it does not take certain key factors into account. Future trends based around disruptive technology and macroeconomic themes are two examples of forces that can significantly influence how the broader stock market will perform in the future.
- Why is the DCF method so widely used?
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Despite its limitations, the discounted cash flow model (DCF) is widely considered the starting point for most stock valuations. The transparent nature of company reports means that any investor can access publicly available information, allowing them to make an informed decision.
Other asset groups, such as commodities, forex, and crypto, do not offer that kind of data, making the DCF model an attractive option for stock investors.
- What is a “value trap”?
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Some stocks are “cheap” because they should be. While it is tempting to purchase stocks that seem undervalued according to a preferred valuation model, not all undervalued stocks present profitable opportunities.
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