Stock Valuation

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21 Aug, 2024

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Stock valuation in finance refers to the valuation method of calculating and estimating the actual value of the stock in the market. The primary purpose of this valuation method is to define whether a particular stock is either underrated or overrated compared to its market value.

John Burr Williams developed the idea for the stock valuation technique for the first time in 1938. It is possible to detect any market correction with this tool. Investors use various methods to assess whether a stock is overvalued, undervalued, or fairly valued. This method is used in various aspects of finance, investment, and corporate decision-making.

What Is Stock Valuation?

Stock valuation refers to the valuation method that uses different formulas to estimate the stock price. It compares the current price to the actual price of the stock.
The concept was first pioneered by Harvard professor John Burr Williams in 1938. As a result, various techniques were developed for the same.
It helps to evaluate whether a stock is undervalued or overvalued. For this, absolute and relative valuation techniques are useful.
Also, different methods like dividend discount model, discounted cash flow, price to earnings ratio, comparable company model, and similar others.

Stock Valuation Explained

Stock valuation refers to a popular concept in finance that helps to determine the actual value of a stock. It allows the traders to estimate the accurate price of the stock compared to its market value. It also constitutes an essential aspect of investing. In addition, it enables a technique to identify the downside risk within the company. Traders, as well as analysts, can utilize this method to value the stocks and create a suited portfolio. As a result, the investors can reduce their investment risk and make informed decisions about buying or selling.

There can be various elements that can influence the stock price. However, in most cases, it involves transaction deals, company news, or market volatility. Due to these, the stock may trade higher than usual. Thus, the majority of traders may follow the same, creating a FOMO (fear of missing out) effect. As a result, the stock price may be traded at a price higher than the listing price. If the stock trades at a price higher than its potential, there can be a hidden risk associated with the firm. However, if this situation continues to an extreme level, it may lead to a bubble formation before the actual market correction.

In any case, if the stock is undervalued, it may trade at a lower price than its potential. Financial and equity analysts tend to use growth stock valuation for analyzing firms. They may utilize different methods and stock valuation formulas to estimate its actual value. Additionally, stock valuation analysis often involves a combination of quantitative and qualitative factors. Thus, investors should regularly update their analyses to reflect changing market conditions and company performance.

Types

Several methods are used for stock valuation, each providing a different perspective on the intrinsic value of a stock. Here are some common types of stock valuation methods:

#1 - Relative Valuation

This method tries to relate (or compare) the firm with others in the same industry. It creates space for the comparison of potential to similar firms. So, if a firm is overvalued, relative valuation with similar firms can determine its true value. The same technique goes for the undervalued stock.

Under this stock valuation analysis, there are sub-methods used to calculate the stock value. The popular methods include comparable company analysis, price-to-earnings ratio, and others.

#2 - Absolute Valuation

The absolute valuation method mainly focuses on the stock fundamentals. It intends to find the intrinsic value of the stock. This technique involves a number of different items from the financial statements to derive this value. It involves cash flows, dividends, weights, and the growth rate of the company. As a result, it is easy to determine the overvalued or undervalued price of a particular stock.

Methods

In contrast to the above types, there are various methods to perform stock valuation. Let us look at them:

#1 - Discounted Cash Flow (DCF)

One popular stock valuation formula is DCF, which utilizes the power of the value of money and future cash flows to determine the future dividend. Also, it considers the free cash flows of the company and brings it to its present value. The main benefit of this DCF is that it does not involve any assumptions on dividends. Thus, it becomes viable to estimate the amount received by the investor on its investment.

#2 - Price-To-Earnings (P/E)

This ratio compares a stock's current price to its earnings per share. A high P/E ratio may indicate an overvalued stock, while a low P/E ratio may suggest undervaluation. Moreover, this ratio is calculated by dividing the market price per share by the earnings per share (EPS).

#3 - Dividend Discount Model (DDM)

Apart from the above methods, DDM is a popular metric to calculate the true value of the stock. It assumes that the dividends represent the cash flows to the firms. As a result, it estimates the present value of the stock by considering the future expected dividends.

#4 - Comparable Company Analysis

As the term itself suggests, the comparable company analysis compares firms in the same sector. So, if the stock price of Company A is very high, and others are ranging at a lower rate, it means the stock is overrated.

#5 - Market Capitalization

This method considers the market cap of different companies. It multiplies the number of shares by the outstanding shares to determine the category of stocks (large, mid, or small cap).

Examples

Let us look at some examples of stock valuation to comprehend the concept better:

Example #1

Suppose Hush Ltd. is a company that manufactures different soft toys and games. They have an acquired share of 80% compared to their peers. As a result, even during listing, the stock saw a massive spike in subscriptions. However, the leading game started after the initial public offering (IPO). Within this time, some traders and analysts felt that the stock may not represent its actual value. Therefore, James and Sheldon decided to perform the stock valuation of Hush Ltd. They utilized the dividend discount model and P/E ratio to determine the actual value.

After evaluation, they realize that the stock is overvalued and may soon witness a market correction. However, other traders were still creating positive sentiments regarding the stock. Therefore, in no time, the prediction of James and Sheldon came true. The Hush stock fell drastically after the police probe found crystals of gold stuffed in the soft toys. As a result, the price of the stock also fell.

Example #2

According to the recent news as of October 2023, the Bank of England warns investors about the major US technology stock valuations. The financial institution feels that these stocks may be overvalued in contrast to their original value. However, it is majorly due to the economic backdrop and rising interest rates. As a result, these stretchy prices will definitely witness a correction in the later stages.

The Bank of England's remarks are made at a moment when a number of well-known technology firms are trading at a significant premium to the S&P 500 due to rising geopolitical concerns and interest rates that are close to record highs.

Despite a decline in several technology stocks subsequent to the recent increase in interest rates, Microsoft, Alphabet, and Nvidia have price-to-earnings ratios of 29, 21, and 31 times their respective subsequent 12-month earnings. The PE for the S&P 500, in contrast, is approximately eighteen times.

Advantages And Disadvantages

Following are the advantages and disadvantages of stock valuation. Let us look at them:

Advantages	Disadvantages
It depicts the true value of the stocks.	Such valuation methods are subject to different assumptions.
This technique establishes an informed way of investment by evaluating a stock.	Some techniques, like DCF and DDM, may have complex procedures to perform.
Moreover, it helps in assessing the risk associated with investment.	Including wrong assumptions may lead to inaccurate results regarding stocks. Also, it evaluates the financial health of the company. Valuation models may need to be better suited for short-term trading decisions, as factors beyond fundamental analysis often influence short-term price movements.
Here, the analysis can guide investors in diversifying their portfolios based on different valuation metrics and industry sectors.	Markets are dynamic, and valuation models may not capture rapid changes in investor sentiment, economic conditions, or geopolitical events.

Frequently Asked Questions (FAQs)

1. What are stock valuation models dependent upon?

Various factors can impact the stock valuation. However, the method of calculation, assumptions, user’s approach, expected dividend, future dividend, and growth rate of the company. They act as the foundation for the valuation model.

2. How to do stock valuation in Excel?

It is possible to perform stock valuation in Excel. However, the format of the model presentation differs. Let us look at some basic steps:
- Decide the type of stock valuation to be performed.
- Gather the necessary information for the same.
- Input the data and apply the relevant Excel formulas for easy calculation. For example, comparable company analysis may have data from different firms.
- Lastly, analyze, compare, and estimate the actual stock value.

3. How do interest rates affect stock valuations?

Interest rates have a strong role to play in the valuation models of the company. Since the capital structure of firms involves a mixture of debt and equity, the cash flows derived also get affected. Thus, if the interest rates tend to rise, the interest payable on the debt taken also rises. Hence, it results in the cash outflow. At the same time, the investment made also increases.