Investors need to determine a stock’s value before investing in a company’s stock. By using proper equity valuation methods, investors can find the fair value of a stock.
The fair value of the stock is not the real worth of the stock but an estimate of what the stock is actually worth.
The fair value of a stock is compared to its market value to determine whether the stock is undervalued, overvalued, or fairly valued.
There are 2 main categories under which a stock can be valued. Investors can either use absolute equity valuations or relative equity valuations.
Methods or models under the absolute valuation category allow the investors to determine the fair value of a stock.
This may include making estimates about future cash flows of the company and discounting them to their present value.
Methods or models under the relative valuation category allow for the comparison of the stocks of different companies with industrial averages or peer groups.
Investors can find different ratios or multiples for a company including the Price-to-Earnings (P/E) ratio, Price-to-Book (P/B) ratio, Price-to-Cash-Flow (P/CF) ratio, etc.
Once these ratios are found, investors compare different stocks based on these ratios to estimate the value of the stocks.
Importance of Equity Valuation
In an efficient market, investors would not need to find the value of stocks. An efficient market is a market in which all information about a stock is readily available to investors. However, efficient markets are theoretical and do not exist in the real world.
A company’s stock can rise and fall due to factors other than the company’s performance.
For example, a rumor generated about a company that is using unethical business practices or about a company that is damaging the environment might cause the company’s stock value to drop regardless of its present or past performances.
Since there are external factors that determine the price of a stock in the market, investors need to know what the real value of a stock is. To find the real value of a stock, investors need to find its fair value or intrinsic value.
Investors who know how to calculate a stock’s fair value can exploit opportunities in the stock market to their advantage.
They can buy undervalued stocks and sell them when the stock prices reach their fair value in the market.
Other than external factors, the main factor that determines the price of a company’s stock is its performance. This gives companies control over the price of their stock in the stock market.
Companies must ensure good performance to raise the price of their stock, further rising the company’s stockholders’ wealth.
On the other hand, companies that cannot perform at a good level will face a drop in the price of their shares in the market.
Equity Valuation Process:
The are 5 steps in the equity valuation process as follows:
1) Understanding the nature of a company and its industry
As previously mentioned, internal and external factors determine the price of a company’s stock. Internal factors include indicators such as the performance of a company, its management structure, its business model, etc.
External factors may include factors such as economic, social, political, technological, etc. factors. Investors must fully understand not only the nature of the company’s business but also the industry the company is operating in, as a whole, and its environment to properly evaluate a stock.
For example, an investor looking to invest in a company must evaluate its past and present performances.
On top of that, investors should also look into any external factors that may affect the value of the company’s stock. Only after understanding these factors should an investor move to the next step.
2) Make forecasts about the company’s performance
Once investors have determined the nature of a company’s business and its industry, they should make reasonable forecasts about the company’s future performance. Investors should base these forecasts on their findings in the first step.
For example, once an investor is done with the 1st step in the process, investors should make forecasts about future revenues, costs, profits, etc. This will show the investors a general picture of how the company will perform in the future.
3) Select an appropriate valuation model
The choice of which valuation model to use will depend on the findings made in 2nd step of the process.
Investors must choose the equity valuation model to use based on the information that is available or has been obtained from the 2nd process. If the information is available, investors can also choose more than one models to use.
For example, if the information from the 2nd step allows for it, investors can choose the absolute valuation method to determine the fair value of a stock.
If the investor has also obtained information about the industry and peer groups, investors can use tools such as the comparables method to find the relative value of a stock.
4) Get an estimated valuation using the selected model
Once an appropriate valuation model has been selected, investors should calculate the value of the stock using the model. The result will give the investors an estimate of how much the stock is worth.
Investors can also use results from different models to obtain more data about the value of the stock but every model will give a different type of result.
For example, once the investor chooses to calculate the absolute value of a stock, the investor can calculate the fair value of the stock using the Dividend Discount Model (DDM) or Discounted Cash Flow Model (DCF).
If the investors opt for relative valuation, they can use the comparables method to compare the value of a stock of a company with its peer group or industry as a whole.
5) Make a decision based on the estimated value
Once an investor evaluates the results from different models, the investor can reach a decision on whether to invest in the stock or not.
This is when investors will look to sell their overvalued shares in the market and try to acquire undervalued shares.
For example, if the fair value of the stock using the Dividend Discount Model is higher than the share price of the stock, it is deemed to be undervalued. This stock will be attractive for potential investors looking to invest in it.
Calculating the value of a stock is very important for investors to determine whether to invest in a stock or not. This is because the value of a stock is also affected by external factors that are not in the company’s control.
Investors must, however, follow a 5 step process to conclude the investment.