Introduction to the valuation of stocks: how to choose the best valuation method

Your goal as an investor should be to find wonderful businesses and invest in them at reasonable prices. If you avoid confusing a large company with being automatically worthy of a large investment, you'll already be ahead of many fellow investors. And that's where the valuation of stocks comes into play.

Valuation is the first step toward smart investing. When an investor tries to determine the value of stocks based on fundamental factors, it helps them make informed decisions about which stocks to buy or sell. Conversely, if a stock doesn't have fundamental value, investors find themselves adrift in a sea of random short-term price movements and visceral sensations.

For years, the financial establishment has promoted the misleading notion that the valuation process should be reserved for experts. But it's not an arcane science that only MBAs and CFAs can practise. With only basic maths skills and some diligence, any investor can determine the values of the best stocks.

Before you can assess a stock, you have to know what a share is. This part of the stock is not a magical creation that flows like the tide. Rather, it's the exact representation of partial ownership in a publicly listed company. For example, if XYZ Corp. has 1 million shares in circulation and you have a single and solitary share, that means you own one-millionth of the company.

Why would someone want to pay you for your millionth? There are quite a few reasons. There will always be someone else who wants one-millionth ownership in the company because they want one-millionth of the votes in a shareholders' meeting. Although the single share here is small in itself, if you combine that millionth with approximately 500,000 of your friends, you suddenly have a majority interest in the company. That means you can make it do all sorts of things, like paying dividends or merging with your company.

Companies also buy shares in other companies for all kinds of reasons. Whether it's via a direct acquisition, in which a company buys all of another company's shares, or a joint venture, in which the company normally buys enough from another company to win a seat on the board of directors, shares are always on sale. The share price translates into the company's worth. This information allows other companies, public or private, to make smart business decisions with clear and concise information about what the shares of another company could cost them.

A portion of the shares is a substitute for the company's shareholders' share in the revenues, profits, cash flow and capital. For an individual investor, however, this usually means worrying about the part of all the numbers that you can get in dividends for as long as the company authorises them. Partial ownership also entitles you to a portion of all dividends. If a company doesn't currently have a dividend yield, there is always the possibility that it may at some point in the future.

Stock Valuation: Basic Concepts

Companies have an intrinsic value based on the amount of free cash flow they can provide during their effective life. However, money in the future is worth less than money now due to inflation, so future free cash flows should be discounted at an appropriate rate.

The theory behind most stock valuation methods is that a company's value equals the total value of all future free cash flows. All future cash flows are discounted due to the decreased value of money over time. If you know all of a company's future cash flows and have an objective rate of return on your money, you can know the exact amount of money you should pay for that company.

However, stock valuation is not so easy in practice because we can only estimate future free cash flows. This valuation approach, therefore, is a mixture of art and science. If we know exactly how much cash flow would be generated, and if we have a known rate of return, we would know exactly what to pay for a dividend stock or any company with positive cash flows, regardless of whether it pays dividends or not. However, the inputs are only estimates and require a degree of skill and experience to be precise.

Three Major Stock Valuation Methods

Many valuation metrics are easily calculated, such as the benefit/price ratio, the price-to-sales ratio or the reserve price. But these numbers only have value in the context of some other form of stock valuation.

The three main stock valuation methods to evaluate a healthy dividend stock are explained below.

Discounted Cash Flow Analysis

The first method, discounted cash flow analysis, treats the company as a large free cash flow machine. We analyse the company as if we bought it all and kept it indefinitely for all of its future free cash flows. If we estimate the value of a company, we can compare it with the company's current market capitalisation to determine if it's worth buying or not. Alternatively, we can divide the total value by the total number of shares and compare this value with the real share price.

Dividend Discount Model

The second method, the dividend discount model, views an individual share as a small free cash flow machine. The dividends are the free cash flow since that is the cash investors receive. In the example of the entire company, a company could spend free cash flows in dividends, buy back shares, perform acquisitions or simply let them accumulate. The point is that investors have little control over what the company's management decides to do with its cash flows. A dividend, however, takes all this into account because the current dividend and the estimated growth of that dividend take into account the company's free cash flows and how management uses those free cash flows.

Multiple Profit Approach

The third method, sometimes called the multiple profit approach, can be used regardless of whether the company pays dividends. The investor estimates the future earnings over a certain amount of time — for example, 10 years — and then places a multiple of hypothetical gains in the estimated final earnings per share (EPS) value. Then, the accumulated dividends are taken into account, and the difference between the price of the current shares and the total hypothetical value at the end of the period is compared to calculate the expected rate of return.

If you want to make an educated estimate about whether a stock's price will go up but don't know how to calculate the valuation of the company's shares, don't be discouraged. Try our free demo account, where you can practice everything you want before moving on to trade and invest with real money.