How To Value a Stock?
Have you ever looked at a stock and asked yourself, “Is it the right price to buy this stock?”. I am sure you have. Most investors struggle with this question, but what is the answer? Just one word, valuation.
In this post on how to value a stock, you will learn very simple valuation methods that can be used to find the right price of any stock.
What is Valuation?
Valuation is all about assessing the intrinsic value of a stock and compare it with the market price in order to understand whether the stock is trading at right price and if you should invest in it. What is intrinsic value? Let me explain, every stock has a business behind it, and every business has a value, which is calculated based on the assets it owns, the cash it has, and it’s estimated future growth and how much capital it can generate in the future from its business.
Based in all these factors, the value of a business is calculated called intrinsic value. Valuation of any stock is all about comparing the intrinsic value and the market value of the stock, and understand if the stock is cheap or expensive.
Valuation of a business can be done by using two different approaches, absolute valuation and relative valuation.
Valuation Approaches. Absolute Vs Relative:
In this section of how to value stocks, we will understand two different valuation approaches and how you can use them to analyze the value of a business.
Absolute valuation is all about understanding the value of a stock and determining the price you are willing to pay for it. If the value of the stock is lower than the price, it becomes a great investment. But how do you assess the value of a stock? Here is a simple example for you to understand.
Imagine you went to buy a shirt for yourself, you like its stitch, its fitting, but the price of the shirt is very high and you cannot afford it. So you decide not to buy it.
Few days later, you visit the same store and find that the same shirt is available at half the price. You immediately decide to buy that shirt.
So, what made you change your decision? Was it just the price? No, the answer is the difference between price and value.
When you looked at the shirt, you assessed the value based on its quality (such as its fabric and stitching) and decided a price you were willing to pay for the shirt . When you found that the price was way too high than your assessed value, you decided not to buy it.
Few days later, when the price dropped to half, it lowered the gap between you perceived value and the price you were willing to pay, making you change your decision.
Absolute valuation works in a similar way.
Every stock has an underlying value, which is based on multiple factors such as past performance, quality of management, its profitability, management efficiency and expected growth in the future. Based on all these factors, you assess a price you are willing to pay for the stock.
If the market price of the stock is much higher than your estimate, the stock is called overvalued, on the other hand if the price of the stock is lower than the price you are willing to pay, its called undervalued.
When you are learning how to value a stock based on absolute valuation models, you look at an individual stock, its past performance and based on these assumptions you make future growth projections, that help you determine a fair value of a stock.
The second approach on how to value a stock is relative valuation. Relative valuation is more popular, and a relatively easier method of valuing a stock.
Relative valuation is all about comparing two or more similar stocks and trying to find out which one is a good investment based on how market values both the assets.
For example, imagine you want to rent a house in a neighborhood. In order to assess how much rent you should pay for the house, you would look for similar houses nearby and try to find what is the average rent paid by the renters in the locality.
Based on this assumption, you will compare the rent you are being asked and assess if its higher or not.
If the rent is comparatively on the higher side, you will bargain for lower rent, if its lower, you would happily accept the offer.
Can you pull the reference how we value stocks based on relative valuation?
Relative stock valuation is similar to the example given above. In relative valuation, you take two companies of the same size, in the same industry and compare the valuation of each stock to understand which stock is cheaper.
Having understood the valuation part, it is now time to look at some of the important valuation methods, using both, relative and absolute valuation approaches.
Types of Absolute Valuation Models:
There are three different valuation models you can use to value a stock, Some of them are very easy to implement, others are slightly lengthy and little difficult. However, all these valuation models are widely used by analysts and investors. Let’s look at each of them and find out how to value a stock. Ready? Read on…
Ben Graham Formula:
One of the easiest formula to implement. Ben Graham’s formula is one of the most simplified stock valuation tool.
Several decades ago, Ben Graham, better known as father of Value Investing and mentor of Warren Buffett, wrote a book called “The Intelligent Investor”. In this book, he laid down a very simple formula for small investors which would help them finding the true value of a stock.
The formula is as follows
Value= EPS * (8.5+2g)
Where: EPS = 12 months trailing EPS
8.5= Assumed P/E Ratio of the Stock
g= Estimated growth rate for the next 7-10 years.
Using the above formula you can calculate the intrinsic value of a company. If the current market price of a stock is above the intrinsic value, it is considered overvalued, if it is trading below the calculated intrinsic value, it is considered undervalued. Simple isn’t it? If you still didn’t get a grasp of it, don’t worry, here is an example to explain it to you.
Let’s take an example to understand how to use the formula:
Example of Kajaria Ceramics: Let’s take Kajaria Ceramics as example to calculate if the stock is undervalued or not.
The trailing 12 month EPS of Kajaria Ceramics is at 13.76 per share.
For estimated growth rate, we have taken 5 years of average net profit growth rate which is around 16% per year.
Putting these numbers in the formula:
= Rs. 557.28
So the intrinsic value of Kajaria Ceramics is around Rs. 557.28 per share.Since Kajaria Ceramics is trading at Rs. 449.8 per share (as on 24 November 2018), we can safely assume that Kajaria Ceramics is undervalued as per the Ben Graham formula.
Dividend Discount Model:
Dividend Discount model is another valuation method used by dividend investors. Most investors invest in stocks for dividend income, and have very little to do with daily market volatility or capital gains.
Dividend discount model helps such investors understand the fair price of a stock based on how much dividend they can expect from the company in the future and what is the fair price to pay for the future returns.
The formula for dividend discount model is as follows:
Price = D/(r-g) Where:
D= dividend per share as per the latest year
r= expected rate of return(i.e. Expected dividend yield in the future)
g= expected growth in dividend every years
Using the formula above, you can calculate the fair price of a stock based on the expected dividend return in the future.
For example: If a stock is paying Rs. 20 per share as dividend per year, you expect a return of 10% every year from the stock, and the expected growth rate in dividends is around 5% the price of the stock would be as follows:
So the fair price for a stock paying dividend of Rs. 20 per share is around Rs 400. If the stock is trading below Rs. 400 per share, it will be assumed to be an undervalued stock, if a stock is trading above Rs. 400, it will be called as an overvalued stock.
Discounted Cash Flow Model:
Discounted Cash Flow Method is one of the most widely used valuation methods used in the financial sector.
Some of the biggest investors in the world like Warren Buffett and many other investment bankers use Discounted Cash Flow method in order to assess the true fair value of a stock.
The reason why discounted Cash flow is so popular is because it is almost impossible to manipulate cash earnings by a company, making cash flows a reliable source of true growth of the company.
In discounted cash flow method, we take last few years of average free cash flow (free cash flow is the cash left with the company after paying for all the capital expenditures) and make predictions about future cash flows based on expected growth rate and discounting the same to the present value in order to arrive at a conclusion of the stock is under or overvalued.
Since calculating Discounted cash flow is a lengthy procedure I would rather write a detailed post explaining step by step procedure on how to do it the right way.
If you want to read about how discounted cash flow works, I would recommend reading the Investopedia’s article on Discounted Cash Flow.
Absolute Valuation models can be of great help if you want to find out the true fair value of a stock.
However, there are some drawbacks of valuing a stock on absolute terms. While absolute valuation give you clear picture of the true value of a stock, it does not tell you if there is a better bargain available in the same sector.
For example, if a stock is trading at 10% discount to its fair value, it does not tell you if there are other stocks in the samne sector that are available at 20% discount.
Since you don’t want to miss a better deal, it is always better to make a comparative analysis with other companies in the same industry to choose the best among equals.
That is where relative valuation helps you.
Types of Relative Valuation Models:
Relative valuation is a valuation approach that allows you to compare two or more companies of the same sector and find which one is a better bargain. In this section we will learn about various relative valuation models and how to value a stock using them.
There are many different types of relative valuation models, but we are going to focus on some of the most popular valuation models that are widely used by the investors and analysts alike:
One of the most popular and widely used relative valuation model is the Price to Earning or P/E ratio.
The formula for P/E Ratio is as follows:
P/E Ratio = Price of Stock/Earning per share
As the formula suggests, P/E ratio simply finds relation between how much a stock/company is earning per share and how much an investor is paying against each rupee earned.
For example if the price of a stock is Rs. 100 and it has an EPS (Earning Per Share) of the company is Rs. 20 per share, the P/E Ratio of the stock will be 5 (100/20=5).
P/E ratio can be used to compare two or more stocks to find which one is a bargain.
For example, consider two stocks, stock X and stock Y. The stock price of X is Rs.100 per share while the stock Y is trading at Rs.500 per share.
Looking at the price, it seems that Y is expensive, of course, why would you pay Rs. 500 when another stock of similar size is available at one fifth the price.
But here is the difference. Let’s assume that stock X has an EPS of Rs. 10 per share while stock Y has an EPS of Rs. 80 per share. No let’s find the P/E of each of these stocks and compare them. The P/E of X is at (100/10=10) while P/e of Y is at (500/80=6.25).
See how picture has changed? Stock X which was looking much cheaper in terms of price now looks expensive as Stock Y has better earning power commanding a higher premium price.
Despite all the goodie goodies about the P/E ratio, there is one major drawback that P/E Ratio does not address.
Warren Buffett says “An investor today cannot profit from yesterday’s growth”
What it essentially means is, just because a stock has done well in the past, does not mean it will not do well in the future.
Since an investor’s return depend heavily on how a company’s business performs in the future, buying a stock solely based on its current valuation could be fatal to your financial future.
So how do you solve this problem? The answer is PEG ratio.
PEG ratio is an extended version of P/E ratio that takes into account expected growth of a company and finds if the stock is over or undervalued.
The formula for PEG ratio is as follows:
PEG = (P/E)/Expected Growth rate.
As a thumb rule,if the PEG ratio of a stock is below 1, it is considered to be undervalued, and if it is above 1, it is considered to be overvalued.
Let’s take an example to understand how using PEG ratio can help us in finding better stocks to invest.
Example: Imagine two stocks X and Y, the X is trading at a PE ratio of 10 while Y is trading at a PE ratio of 15. At first it seems that X is cheaper than Y as its trading at lower PE.
But here domes that catch, what if X is expected to grow at 10% every year while Y is expected to grow at 20%?
In this case the PEG ratio of X and Y respectively will be as follows:
PEG of X= 10/10=1
PEG of Y= 15/20=0.75
See how things changed? By looking at just the PE ratio X looked much cheaper, but now after using PEG ratio for valuation, Y looks much cheaper as it is expected to grow at a higher rate compared to X.
Word Of Caution:
Every coin has two sides, and the same can be said about valuing a stock. There are many advantages and disadvantages associated with valuation.
In this section of how to value a stock, you will learn about some pitfalls of valuation that you should be aware in order to be able to value stocks in a better way.
Garbage in Garbage Out:
Valuation is simply projections based on your assumptions of how you expect a company to perform in the future. In order to arrive at accurate valuations, you must be able to make accurate assumptions about the stock’s growth.
The more inaccurate your assumptions are the more inaccurate your valuations will be. That is why if your assumptions are garbage, the valuations arrived at will be garbage as well.
This does not mean that you have to be accurate at assuming about your future growth assumptions of a stock. What it means is, that you must be flexible with your valuations and should not shy away from being flexible with them, which is our next point.
Don’t be too Rigid With Your Valuation:
Aswath Damodaran, Professor of Finance in New York University, called the God of Valuation said in hi book “Little Book of Valuation” “Every valuation is biased, you cannot start valuing a company from a clean slate, in fact the very basis of valuing a company starts when you hear something about a company”
What he really means is, every valuation has some biases which is based on an individual’s assumption of how a company will grow in the future. The more optimistic your expectations are higher will be your intrinsic value. So don’t be too rigid with your valuations, and try to revise your assumptions based on new outcomes and events that may affect valuations of the stock.
Valuing a stock is not just about numbers. Just because you can fill an excel sheet with numbers does not make you a valuation expert.
Every valuation has a story, which has lot of variables such as how the business is planning to grow, what are the growth drivers working in its favor? How honest and able is the management of the company? What are the challenges the company might face in the future? Will the competition be tough?
The real art of valuation lies in putting all these non-numerical variables into an excel sheet and derive its true value, which can only be learned by making mistakes and learning from your experiences.
That concludes my guide on how to value a stock. I hope you liked it and found it knowledgeable. Do let me know in the comment section which valuation model did you find the most useful and if you have any doubts, you can always mail me on the address given on top.