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How Do Stock Valuation Different Valuation Methods/Approaches Works?

Value Investment and Mindset

How Do Different Stock Valuation Valuation Methods/Approaches Works?

As we discussed the evaluation of intrinsic value in the previous topic, “How to Pick Good Stocks as a Value Investor?”

Let’s get into the details of the different valuation methods and approaches used by value investors.

The important thing to keep in mind is that there is no right or wrong way to value stock. It depends on your preference for which valuation method is more suitable for that particular company. Valuation is just a guideline for making wiser investment decisions.

Different people might have different intrinsic values for their businesses. No one knows the exact intrinsic value.

We are going to discuss in detail the Discounted Cash Flow (DCF) method, step-by-step valuation methods via the DCF approach.

🔶Step 1: Find the average growth of Free Cash Flow in 3-5 years period

Example: If company A has a 20% average growth in free cash flow from 2015 to 2020,. Observe the growth of numbers in terms of percentage.

For instance, let’s say a company has a free cash flow of 10,00,000 in 2015, and the year after, the company has increased its free cash flow to 12,00,000 (20%), and for 5 years [2015-2020], it will be similar to around 20% as well.

🔶Step 2: Estimate the discount rate

Warren Buffet uses the U.S. 10-year Treasury rate/risk free rate.

Example: U.S. 10-year treasury rate = 1.52 adjusts to reasonable rate, which is around 3%

Since the purpose of this approach is to discount the cash flow back to its present value to evaluate the stock price, a discount rate is a must for this approach.

Theoretically, people always use the weighted average cost of capital as the discount rate, as it is a measure of what it costs a company to acquire funding. However, this measurement comes with many false assumptions and simplifications of reality and this formula is complex and not beginner friendly

Also, the popular value investor Warren Buffett doesn’t use this. He only uses the US 10-year Treasury rate as a discount rate, as it represents the long term return that investors can expect to receive from the US government for practically taking no risk, or what we called the risk free rate.

But sometimes the rate is not consistent, so what we need to do is adjust the rate so that the valuation is more feasible.

Now let’s take a look at different types of companies in the market and how to evaluate these types differently.

Growth Play Company
Dividend Play Company
Asset Play Company

Each company has a different valuation approach. Let’s take a look at other things to calculate for each company.

🔶Growth Play Company

DCF (discount cash flow) is the valuation approach (discussed above).
Price-to-earnings to growth ratio (PEG)
Price-to-sales ratio (P/S)

🔸Price-to-earnings to Growth Ratio (PEG)

PEG is a company’s price-to-earnings ratio (P/E) divided by its annual earnings per share growth rate.

It adjusts the traditional P/E ratio by considering the growth rate in EPS that is expected in the future.

P/E ratio is the ratio of valuing a company that measures its current share price relative to EPS.

It basically tells us how much more we are paying for the ability of a company to earn profits. Also, it tells us how many years it takes us to break even.

Example:

Share Price (SP) = $ 341.66 Per share

Earnings per share (EPS) = 10.09

PE Ratio = SP / EPS

341.66/10.09 = 33.86

Average EPS growth rate = 30%

PEG Ratio = PE Ratio / Average EPS growth rate

= 33.86/30

= 1.13

Since the valuation method is to determine whether the price is overvalued, fair, or undervalued.

PEG Ratio = 1 (Fair)

PEG Ratio > 1 (Overvalued)

PEG Ratio < 1 (Undervalued)

PEG ratio does not consider other growing factors, such as the amount of cash a company keeps on its balance sheet.
The valuation results might be different from those of other valuation approaches.

🔸PS ratio

A price-to-sales ratio is a valuation rate that compares a company’s stock price to its revenue, or sales per share.

It is an indicator of the value that financial markets have placed on each dollar of a company’s sales or revenue.

The lower the PS ratio, the more attractive the investment.

Example:

Meta (Formerly FB), let’s suppose their share price = 341.66

Total outstanding share = 2.88 Bn

Total Revenue (2020 Yr) = $85.97 Bn

Sales per share = Total Revenue / Total outstanding shares

= 85.97 / 2.88

= $29.85

PS Ratio = Share price / Sales per share

= 341.66 / 29.85

= 11.45

Compare the PS ratio with other competitors in the same industry, if it is lower than the average PS ratio, it can be considered undervalued.
Compare the current PS ratio with the 3-year average PS ratio to determine the intrinsic value
Sales numbers are harder to manipulate than main numbers.

So as financial investors, we must always consider other financial metrics when determining whether a stock is valued.

🔶Dividend Play Company

It uses a dividend yield valuation approach for valuation. Dividend yield is the financial ratio, by dividing the expected dividend per share with its current stock price. It is simple compared to other methods.

Example:

Stock Price = $100 per share

Annual Dividend = Rs 5 per share

Dividend Yield = Annual Dividend/Stock Price

= 5/100 * 100 %

= 5%

When the stock price increases, the dividend decreases.

Dividend Yield > 5% (Undervalued)

Dividend Yield < 5% (Overvalued)

Important factors about dividend play:

Only applicable to stable companies with stable and consistent dividend payouts.
Stay away from companies that pay out a high percentage of dividends, but whose share price is unstable and volatile.

The reason behind these important factors is simple, Let’s take a look at this scenario:

Imagine a company with a 10% dividend yield having a 30% decline in share price after a year, Let’s say we invested Rs1000 for Rs 100 per share. After a year, your return for that stock will be -20%. So remember, if you want to invest in a dividend company, choose a stable one with a consistent dividend payout.

🔶Asset Play Company

An asset-play company is a company with assets that are not believed to be accurately reflected in its stock price. Asset play has higher asset value compared to its market capitalization.

Example: Walmart, Real Estate, and the banking industry.

It uses Price-to-Book Ratio (PB)
It is a financial ratio specifically for asset play companies to find out the value of the company if it is closed or sold today.

Asset play companies might have fallen in terms of growth, but they can still be a good value based on their assets.

Book Value = Total Assets - Total Liabilities

Let’s go through an example of Walmart:

Current Book Value = $87.55 Bn

Total Outstanding Share = 2.82 Bn

Book Value Per Share = Current Book Value/Total Outstanding Share

= 87.53/2.82

= 31.04

Stock Price = $141.87 Per share

PB Ratio = Stock Price / Book Value Per Share

= 141.87/31.04

= 4.57

PB Ratio > 1 (Overvalued)

PB Ratio < 1 (Undervalued)

Lower the Better

PB Ratio ignores intangible assets such as a company’s brand name, patents, and other intellectual property.
It is a valuation approach that is only suitable for asset play companies.

Overall, the fundamentals of the business and its values matter the most. Do not rely on specific factors in the valuation method while investing.

#stockmarket #finance #investing #market #shares #company #stockvaluation #stocks #valuationmethods #PBratio #DCFmethod #PEGratio #PSratio #dividend #dividendyield #companies #money #valueinvestor #investorv #growthplaycompany #assetplaycompany #dividendplaycompany

Last Updated: Sep 10, 2024

Tags: #stockmarket #finance #investing #market #shares #company #stockvaluation #stocks #valuationmethods #PBratio #DCFmethod #PEGratio #PSratio #dividend #dividendyield #companies #money #valueinvestor #investorv #growthplaycompany #assetplaycompany #dividendplaycompany Category: Finance & Investment Learning Lifestyle