Choosing the most suitable method of stock valuation
Beginner Stock Market Investing, Stock Market Investing Strategies
If you are figuring out what valuation method to use for valuing your stock investments, you will quickly realize that there are many different methods that are available ranging from the simple methods to the more complicated methods such as discounted cash flow valuation. You should know that there is no single method that can be used universally. Because every company is unique and every industry has special factors to be taking into account, you may have to use different techniques depending on the exact circumstances…
All these techniques fall into two broad categories namely absolute valuation and relative valuation. The methods used for absolute valuation tend to use only fundamental analysis to determine the intrinsic value of a stock. This means that you would only look at numbers for a particular company such as cash flow and potential growth in sales and profits without worrying about the competition or the industry. Techniques that use this approach include the dividend discount model, the discounted cash flow model and so on.
In contrast, relative valuation techniques involve the comparison of the company in question to similar companies. The methods used in generally consist of calculating ratios such as multiples or price/earnings ratios and comparing them to the ratios of similar companies to determine whether the company is undervalued or overvalued. For instance, if the price-earnings ratio is lower for a particular company than the ratio of comparable companies, it would be fair to say that the company appears to be undervalued. Relative valuation techniques are pretty straightforward and easy-to-use which is why they are the starting point for many investors including novices.
The Comparables Method is the way to go if you do not understand the more complicated methods or simply do not wish to waste your time on the necessary number crunching. The method does not bother about the intrinsic value of a particular stock but only compares a particular ratio for a stock to a benchmark ratio (for instance, and the average for similar companies). The underlying principle of this method is called the Law of One Price which states that similar assets should be priced similarly. This simplicity accounts for the popularity of the method.
Because of the large number of ratios that are available for comparison, the method can be used universally by picking the right ratio. You can use the ratios such as price/earnings, price/book, price/sales and so on. Because it is generally acknowledged that one of the principal drivers of the price of a stock is the earnings and the earnings outlook, the most commonly used ratio tends to be the price/earnings ratio. This ratio is generally suitable if:
- The company is publicly traded because you need a stock price for the calculation
- The company is profit making because a negative ratio is meaningless in terms of analysis
- The earnings are relatively steady and not distorted by the accounting treatment
In summary, no one valuation method is perfect and you should use the method that suits your skills and your capabilities. Nor are you restricted to one method because some investors use multiple methods to create a price range or simply to calculate an average value that can be used for comparative purposes.
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