How to Value Stocks

There are several ways to value stocks, including using fundamental analysis, technical analysis, and discounted cash flow analysis.

Fundamental analysis involves looking at the company's financial statements, such as its income statement, balance sheet, and cash flow statement, to determine its overall financial health and future growth prospects.

Technical analysis involves studying charts and historical data to identify patterns and trends that can indicate whether a stock is likely to rise or fall in the future.

Discounted cash flow (DCF) analysis involves estimating the future cash flow a company will generate and then discounting that amount back to its present value. This can give a more accurate picture of a stock's true worth.

Ultimately, the most effective method for valuing a stock will depend on the individual stock and the information available. It's important to consider multiple methods and to do your own research before making any investment decisions.

How to Determine What a Share of Stock Is Worth

Determining the worth of a share of stock can be a complex process, as the value of a stock is ultimately determined by the market and can fluctuate based on a variety of factors. However, there are several methods that analysts and investors use to estimate the value of a stock, including:

Absolute (Intrinsic Value)

The intrinsic value of a stock is the underlying or true value of a stock, independent of its market price. It represents the value of a stock based on an underlying perception of its true worth, including all aspects of the business, its assets, and its future prospects.

There are different ways to estimate the intrinsic value of a stock, including:

  • Dividend Discount Model (DDM). This model estimates the intrinsic value of a stock by estimating the future cash flows the stock will generate and discounting them back to their present value.

  • Discounted Cash Flow Model (DCF). This method involves estimating a company's future cash flows and discounting them to their present value. This can give a more accurate picture of a stock's true worth.

  • Earnings Power Value (EPV). Assumes that there is no growth. A method of valuing a stock that is based on the company's earning power, or the amount of money it generates in profits. The basic idea behind EPV is that a stock's value is directly related to the company's earning power, and that the stock's true value can be determined by estimating the company's earning power over time.

  • Weighted Average Cost of Capital (WACC) is a financial metric that represents a company's overall cost of capital, which includes both debt and equity financing. It is used to determine the minimum return a company must earn on its existing assets to satisfy its creditors and shareholders.

Relative (The Comparables Model)

This method involves looking at the financials of similar companies in the same industry to gauge the value of the stock.

  • Price-to-Earnings (P/E). This ratio compares the stock's current price to its earnings per share (EPS). A high P/E ratio may indicate that the stock is overvalued, while a low P/E ratio may indicate that it is undervalued.

  • EV/EBITDA. EV/EBITDA (Enterprise Value to Earnings Before Interest, Taxes, Depreciation and Amortization) is a financial ratio that compares a company's enterprise value to its EBITDA. Enterprise value (EV) is a measure of a company's total value, including debt and equity, while EBITDA is a measure of a company's operating performance.

The Dividend Discount Model (DDM) Formula

The Dividend Discount Model (DDM) is a method of valuing a stock that is based on the dividends the stock is expected to pay in the future. The basic idea behind DDM is that the value of a stock is equal to the present value of all future dividends.

To calculate the intrinsic value of a stock using DDM, an analyst will need to estimate the future dividends the stock will pay, the discount rate to be used, and the number of years over which the dividends will be paid.

The formula for DDM is as follows:

Intrinsic Value = (Expected Dividends / (Discount Rate - Dividend Growth Rate))

Expected Dividends: It's an estimation of the future dividends the stock will pay. It can be calculated by taking the company's last dividend per share and projecting it into the future.

Discount Rate: It's the rate at which future cash flows are discounted to their present value.

Dividend Growth Rate: It's the rate at which dividends are expected to grow in the future.

The DDM is a simple and easy way to estimate the intrinsic value of a stock, but it relies on accurate estimates of future dividends, discount rate, and dividend growth rate. The DDM can be used in conjunction with other methods of stock valuation, such as discounted cash flow analysis, to provide a more accurate picture of a stock's true worth.

How to Calculate Discounted Cash Flows (DCF)

Discounted cash flow (DCF) analysis is a method used to determine the value of an investment based on its expected cash flows. The basic idea behind DCF is that the value of an investment is the present value of its expected cash flows. To calculate the discounted cash flows, you need to follow these steps:

  1. Forecast the expected cash flows for the investment. This typically includes projected income and expenses for a specific period of time, such as 5 or 10 years.

  2. Determine the discount rate to use in the analysis. The discount rate represents the opportunity cost of investing in the project, and typically includes the investor's required rate of return as well as any other risk factors associated with the investment.

  3. Use the discount rate to calculate the present value of each projected cash flow. This is done by dividing the projected cash flow by (1 + discount rate) raised to the power of the number of years in the future the cash flow is projected to occur.

  4. Sum the present values of all the projected cash flows to arrive at the total present value of the investment.

  5. Compare the total present value of the investment to the initial cost of the investment. If the present value is greater than the initial cost, the investment is considered to be a good value; if the present value is less than the initial cost, the investment is considered to be overpriced.

It is important to note that the accuracy of a discounted cash flow analysis depends on the accuracy of the projected cash flows and the chosen discount rate. Therefore, it's important to use realistic cash flow projections and a conservative discount rate.

Calculating Earnings Power Value (EPV)

Earnings Power Value (EPV) is a valuation method that is used to determine the intrinsic value of a company by focusing on its earning power. The EPV formula is used to calculate the present value of future earnings. The basic idea behind EPV is that a company's true worth is determined by its ability to generate earnings, rather than by its assets or revenues.

To calculate the Earnings Power Value of a company, you need to follow these steps:

  1. Determine the company's Earnings Before Interest and Taxes (EBIT). This is calculated by subtracting the company's operating expenses from its revenues.

  2. Determine the company's Cost of Capital (CoC). The CoC is the rate of return required by investors for investing in the company. This can be calculated by using the Capital Asset Pricing Model (CAPM) or by using the Weighted Average Cost of Capital (WACC).

  3. Determine the company's Sustainable Growth Rate (SGR). The SGR is the rate at which a company can grow its earnings without needing to raise additional capital. It can be calculated by using the formula SGR = (ROE x (1- payout ratio))/ CoC.

  4. Calculate the EPV by using the formula EBIT / (CoC - SGR). The result is the present value of future earnings, which represents the intrinsic value of the company.

  5. Compare the calculated EPV to the current market value of the company. If the EPV is greater than the current market value, the company may be undervalued and a good investment opportunity. If the EPV is less than the current market value, the company may be overvalued and not a good investment opportunity.

It's important to note that EPV is a relative measure, and it should be used in conjunction with other valuation methods. Additionally, it is important to use realistic assumptions while forecasting the EBIT, CoC, and SGR.

Calculating Weighted Average Cost of Capital

The Weighted Average Cost of Capital (WACC) is a measure of a company's cost of capital in which each category of capital is proportionately weighted. It is used to determine the minimum return a company must generate in order to meet the expectations of its investors. It is also used as a discount rate to calculate the present value of future cash flows in discounted cash flow (DCF) analysis. The WACC is calculated as follows:

  1. Determine the company's cost of each form of capital, including the cost of debt, the cost of preferred stock, and the cost of common equity.

  2. Determine the proportion of each form of capital in the company's financing structure. This includes the proportion of debt, preferred stock, and common equity.

  3. Calculate the cost of each form of capital by multiplying the cost of each form of capital by its proportion in the financing structure.

  4. Sum the costs of each form of capital to arrive at the WACC. The formula is:

WACC = (E/V) * Ce + (D/V) * Cd * (1-Tc)

Where:

  • E/V = proportion of equity in the company's financing structure

  • Ce = cost of equity

  • D/V = proportion of debt in the company's financing structure

  • Cd = cost of debt

  • Tc = the corporate tax rate

It's important to note that the WACC is a long-term average, it should be periodically updated to reflect changes in the company's financing structure and the cost of capital. Additionally, the WACC is sensitive to the cost of each form of capital and the weight of each form of capital, so it is important to use realistic assumptions while calculating it.

How to Calculate Prices-to-Earnings (P/E) Ratio

The P/E ratio is calculated by dividing the current market price of a stock by its earnings per share. The formula is:

P/E ratio = Market Price per Share / Earnings per Share (EPS)

For example, if a company's stock is currently trading at $50 per share and its earnings per share for the last 12 months is $5, the P/E ratio would be:

P/E ratio = $50 / $5 = 10

A lower P/E ratio generally indicates that a stock is undervalued, while a higher P/E ratio generally indicates that a stock is overvalued. A P/E ratio of 15 is considered to be average, but it can vary depending on the industry and the stage of the company.

How to Calculate EV/EBITDA

The formula for EV/EBITDA ratio is:

EV/EBITDA ratio = Enterprise Value / EBITDA

To calculate the EV/EBITDA ratio, you first need to calculate the Enterprise Value (EV) of the company. The EV is the total value of the company, including both debt and equity. It can be calculated using the following formula:

EV = Market Capitalization + Total Debt - Cash and Cash Equivalents

Once the EV is calculated, the EBITDA can be calculated by adding the following elements to the Net Income:

EBITDA = Net Income + Interest + Taxes + Depreciation + Amortization

For example, if a company has an enterprise value of $500 million, and an EBITDA of $100 million, the EV/EBITDA ratio would be:

EV/EBITDA ratio = $500 million / $100 million = 5

A lower EV/EBITDA ratio generally indicates that a stock is undervalued, while a higher EV/EBITDA ratio generally indicates that a stock is overvalued.

End of Lesson

Valuing stocks is the process of determining the intrinsic value of a company's stock by analyzing its financial and economic characteristics. There are several methods that can be used to value stocks, including discounted cash flow (DCF) analysis, earnings power value (EPV) analysis, and the price-to-earnings (P/E) ratio.