Introduction to the valuation of stocks: how to choose the best valuation method?
13 Aug 2018
Investors often erroneously assume that a large company means a large investment. Finding solid companies is crucial in the investment process, but it is equally important to determine what value the stocks of these companies have. 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 a large investment, you will already be ahead of many of your investing peers. And that's where the valuation of stocks comes into play.
Valuation is the first step towards smart investing. When an investor tries to determine the value of the stocks based on fundamentals, it helps them make informed decisions about which stocks to buy or sell. Without fundamental value, one finds oneself adrift in a sea of random movements of short-term prices and visceral sensations.
For years, the financial establishment has promoted the misleading notion that valuation should be reserved for experts. However, it is not an arcane science that can only be practiced by MBAs and CFAs. With only basic math skills and some diligence, any investor can determine the values of the best stocks.
Before you can assess a stock, you have to have some notion of what a share is. This part of the stock is not a magical creation that flows like the tide; rather, it is the exact representation of the partial ownership of a listed company. 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, really. There will always be someone else who wants one millionth of the property because he wants one millionth of the votes in a shareholders' meeting. Although it 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 her do all sorts of things, like paying dividends or merging with your company.
Companies buy shares in other companies for all kinds of reasons. Whether it's a direct acquisition, in which a company buys all the shares, or a joint venture, in which the company normally buys enough from another company to win a seat on the board of directors, the shares are always at the sale. The share price translates into the company price, thus being on sale for seven and a half hours per day, five days a week. It is this information that 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 a share in the revenues, profits, cash flow and capital of the company's shareholders. For an individual investor, however, this usually means worrying about the part of all the numbers that you can get in dividends. A portion of the property entitles you to a portion of all dividends in perpetuity. Even if the company's shares do not currently have a dividend yield, there is always the possibility that at some point in the future there might be some type of dividend.
Stock Valuation: Basic Concepts
Companies have an intrinsic value, and that intrinsic value is 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, so future free cash flows should be discounted at an appropriate rate.
The theory behind most stock valuation methods is that the value of a company is equal to the sum value of all future free cash flows. All future cash flows are discounted due to the value of money over time. If you know objectively all the future cash flows of a company and have an objective rate of return on your money, then 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. Given the inputs, the outputs are real. If we knew exactly how much cash flow would be generated, and if we had an objective 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 a dividend or not. But the entries themselves are only estimates and require a degree of skill and experience to be precise. Therefore, stock valuation is art and science.
Three Major Stock Valuation Methods
Many of the valuation metrics are easily calculated, such as the price-benefit ratio, or price-sale, or price-reserve. But these are numbers that only have value with respect to some other form of stock valuation.
The three main methods of stock valuation to evaluate a healthy dividend stock are the following.
Discounted Cash Flow Analysis
The first method, the discounted cash flow analysis, is to treat the company as a large free cash flow machine. We analyze the company as if we bought it all and kept it indefinitely for all its future free cash flows. If we estimate the value of a company, we can compare it with the current market capitalization of that company to determine if it is worth buying it or not, or alternatively, we can divide the total value calculated 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, is to treat an individual share as a small free cash flow machine. The dividends are the free cash flow, since that is the cash that we receive as investors. In the example of the entire company, a company could spend free cash flows in dividends, buy back shares, acquisitions or simply let it accumulate in the balance, and the point is that we have little control over what the administration decides to do with it. The dividend, however, takes all this into account, because the current dividend, as well as the estimated growth of that dividend, takes into account the company's free cash flows and how the administration is using those free cash flows.
Multiple Profit Approach
The third method, sometimes called multiple profit approach, can be used regardless of whether the company pays a dividend. The investor estimates the future earnings over a period of time, for example ten years, and then places a multiple of hypothetical gains in the estimated final 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 time period is compared to calculate the expected rate of return.
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