Stock valuation


Stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value.
A target price is a price at which an analyst believes a stock to be fairly valued relative to its projected and historical earnings.
In the view of fundamental analysis, stock valuation based on fundamentals aims to give an estimate of the intrinsic value of a stock, based on predictions of the future cash flows and profitability of the business. Fundamental analysis may be replaced or augmented by market criteria – what the market will pay for the stock, disregarding intrinsic value. These can be combined as "predictions of future cash flows/profits ", together with "what will the market pay for these profits?" These can be seen as "supply and demand" sides – what underlies the supply, and what drives the demand for stock?
Stock valuation is different from business valuation, which is about calculating the economic value of an owner's interest in a business, used to determine the price interested parties would be willing to pay or receive to effect a sale of the business.
Re. valuation in cases where both parties are corporations, see under Mergers and acquisitions and Corporate finance.

Fundamental criteria (fair value)

There are many different ways to value stocks. The key is to take each approach into account while formulating an overall opinion of the stock. If the valuation of a company is lower or higher than other similar stocks, then the next step would be to determine the reasons.
The first approach, fundamental analysis, is typically associated with investors and financial analysts - its output is used to justify stock prices.
The most theoretically sound stock valuation method, is called "income valuation" or the discounted cash flow method. It is widely applied in all areas of finance.
Perhaps the most common fundamental methodology is the P/E ratio. This example of "relative valuation" is based on historic ratios and aims to assign value to a stock based on measurable attributes. This form of valuation is typically what drives long-term stock prices.
The alternative approach – Technical analysis – is to base the assessment on supply and demand: simply, the more people that want to buy the stock, the higher its price will be; and conversely, the more people that want to sell the stock, the lower the price will be.
This form of valuation often drives the short-term stock market trends; and is associated with speculators as opposed to investors.

Discounted cash flow

The discounted cash flow method involves discounting of the profits that the stock will bring to the stockholder in the foreseeable future, and sometimes a final value on disposal, depending on the valuation method. DCF method assumes that borrowing and lending rates are same. The discounted rate normally includes a risk premium which is commonly based on the capital asset pricing model.
For discussion of the mechanics, see Valuation using discounted cash flows.
In July 2010, a Delaware court ruled on appropriate inputs to use in discounted cash flow analysis in a dispute between shareholders and a company over the proper fair value of the stock. In this case the shareholders' model provided value of $139 per share and the company's model provided $89 per share. Contested inputs included the terminal growth rate, the equity risk premium, and beta.

Earnings per share (EPS)

EPS is the net income available to common shareholders of the company divided by the number of shares outstanding. Usually, there will be two types of EPS listed: a GAAP EPS and a Pro Forma EPS, which means that the income has been adjusted to exclude any one time items as well as some non-cash items like amortization of goodwill or stock option expenses. The most important thing to look for in the EPS figure is the overall quality of earnings. Make sure the company is not trying to manipulate their EPS numbers to make it look like they are more profitable. Also, look at the growth in EPS over the past several quarters / years to understand how volatile their EPS is, and to see if they are an underachiever or an overachiever. In other words, have they consistently beaten expectations or are they constantly restating and lowering their forecasts?
The EPS number that most analysts use is the pro forma EPS. To compute this number, use the net income that excludes any one-time gains or losses and excludes any non-cash expenses like amortization of goodwill. Never exclude non-cash compensation expense as that does impact earnings per share. Then divide this number by the number of fully diluted shares outstanding. Historical EPS figures and forecasts for the next 1–2 years can be found by visiting free financial sites such as Yahoo Finance.

Price to Earnings (P/E)

Now that the analyst has several EPS figures, the analyst will be able to look at the most common valuation technique used, the price to earnings ratio, or P/E. To compute this figure, one divides the stock price by the annual EPS figure. For example, if the stock is trading at $10 and the EPS is $0.50, the P/E is 20 times. A complete analysis of the P/E multiple includes a look at the historical and forward ratios.
Historical P/Es are computed by taking the current price divided by the sum of the EPS for the last four quarters, or for the previous year. Historical trends of the P/E should also be considered by viewing a chart of its historical P/E over the last several years. Specifically, consider what range the P/E has traded in so as to determine whether the current P/E is high or low versus its historical average.
Forward P/Es reflect the growth of the company into the future. Forward P/Es are computed by taking the current stock price divided by the sum of the EPS estimates for the next four quarters, or for the EPS estimate for next calendar or fiscal year or two.
P/Es change constantly. If there is a large price change in a stock, or if the earnings estimates change, the ratio is recomputed.

Growth rate

based valuations rely heavily on the expected growth rate of a company. An accurate assessment is therefore critical to the valuation
Here, the analyst will typically look at the historical growth rate of both sales and income to derive a base for the type of future growth expected.
However, since, companies are constantly evolving, as is the economy, solely using historical growth rates to predict the future will not be appropriate.
These, instead, are used as guidelines for what future growth "could look like" if similar circumstances are encountered by the company.
Calculating the future growth rate, therefore, requires personal investment research – familiarity with a company is essential before making a forecast.
This may take form in listening to the company's quarterly conference call or reading a press release or other company article that discusses the company's growth guidance.
However, although companies are in the best position to forecast their own growth, they are often far from accurate; further, unforeseen macro-events could cause impact the economy and /or the company's industry.
Regardless of research effort, a growth-rate based valuation, therefore, relies heavily on experience and judgement, and analysts will thus make inaccurate forecasts.
It is for this reason, that analysts often display a range of forecast values, especially based on different terminal value assumptions.

Capital structure substitution - asset pricing formula

The capital structure substitution theory describes the relationship between earnings, stock price and capital structure of public companies. The equilibrium condition of the CSS theory can be easily rearranged to an asset pricing formula:
where
The CSS theory suggests that company share prices are strongly influenced by bondholders. As a result of active repurchasing or issuing of shares by company managements, equilibrium pricing is no longer a result of balancing shareholder demand and supply. The asset pricing formula only applies to debt-holding companies.
The asset pricing formula can be used on a market aggregate level as well. The resulting graph shows at what times the S&P 500 Composite was overpriced and at what times it was under-priced relative to the capital structure substitution theory equilibrium. In times when the market is under-priced, corporate buyback programs will allow companies to drive up earnings-per-share, and generate extra demand in the stock market.

Price earnings to growth (PEG) ratio

This valuation technique has become popular over the past decade or so. It is better than simply looking at a P/E because it takes three factors into account; the price, earnings, and earnings growth rates. To compute the PEG ratio, the Forward P/E is divided by the expected earnings growth rate. This will yield a ratio that is usually expressed as a percentage. The conjecture goes that as the percentage rises over 100% the stock becomes more and more overvalued, and as the PEG ratio falls below 100% the stock becomes more and more undervalued. The conjecture is based on a belief that P/E ratios should approximate the long-term growth rate of a company's earnings. Whether or not this is true will never be proven and the conjecture is therefore just a rule of thumb to use in the overall valuation process.
Here is an example of how to use the PEG ratio to compare stocks. Stock A is trading at a forward P/E of 15 and expected to grow at 20%. Stock B is trading at a forward P/E of 30 and expected to grow at 25%. The PEG ratio for Stock A is 75% and for Stock B is 120%. According to the PEG ratio, Stock A is a better purchase because it has a lower PEG ratio, or in other words, its future earnings growth can be purchased for a lower relative price than that of Stock B.