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Understanding Stock Valuation

Stock valuation is the technique of using predetermined formulas that includes different economic indicators to calculate theoretical values of companies and their stocks. There are several ways to calculate stock valuation but the chosen method must be executed accurately so that the price of the stock can be properly valued.

Finding a Method for You

If it is an investor’s first time in trying to value a stock, they might find it overwhelming to find out the amount of valuation techniques available. There are pretty straightforward ones like the comparable method and there are more complicated ones like the discounted cash flow and residual income models.

However, it is an unfortunate fact that no one method can be suited for every situation as each stock differs from one another.

Categories

The methods for stock valuation falls into two categories: Absolute valuation models and relative valuation models.

Absolute Valuation Models

This focuses on the true value of an investment based solely on the fundamentals. The valuation methods that fall into this category are dividend discount mode and discounted cash flow model.

Relative Valuation Models

This method works by comparing one company to companies of the same type, this is the opposite of the absolute valuation mode. This method involves calculating rations like the price-to-earnings multiple.

This method is favored by most analysts because they find it to be simpler and more efficient to do.

Valuation Methods

Dividend Discount Model

This method uses the dividends companies pay its shareholders to calculate the value of a firm. Dividends signify the current value of the cash flow that goes to the shareholder, in this way, analysts can figure out how much the shares should be worth.

Discounted Cash Flow Model

This method applies to companies that either don’t pay a dividend or have an irregular dividend pattern. This method uses the discounted future cash flow of the company to value the business.

Comparable Method

If for some reason you find any of the methods above unsuitable for use, the Comparable Method should be considered. This method compares stock price multiples to determine if a stock is under or overvalued unlike the previous methods that attempts to figure out the true value of the stock.