Top 5 Methods for Accurate Stock Valuation

Top 5 Methods for Accurate Stock Valuation

NIWS Team 25 Jul 2024

Are you a share market enthusiast looking to earn profits from stocks? If yes, you must know accurate stock valuation methods to make the best investment decisions, manage your portfolio, assess risks, and plan strategically! 

Stock valuation determines a stock's intrinsic value to assess whether it is overvalued, undervalued, or reasonably priced. Once identified, there are many opportunities to invest and book profits in underpriced stocks, sell overpriced ones, and hold reasonably priced ones. 

But the question remains: How do you evaluate a stock? In this blog, our experts from NIWS, one of the best stock market institutes in Jaipur, Delhi and Indore, will assist you with the five best stock valuation methods, which even a beginner or a pro stock market enthusiast can grasp to book the most profits!

Let’s get into the details to know it all! 

 

Types of Stock Valuation

Before we get into the details of stock valuation methods, let’s first explore how they are done!  

Absolute

In this method, stock valuation is based on a business's fundamental analysis, which is conducted using information collected through financial statements. These methods focus on a company's underlying financial health and future cash flows, independent of its current market price. 

Relative

Relative stock valuation is a method of comparing financial ratios between similar companies. These methods use valuation multiples from comparable companies to determine whether a stock is reasonably priced.

 

Methods for Accurate Stock Valuation

The top methods for an accurate stock valuation include the following-

 

#1 - Discounted Cash Flow (DCF) Analysis

DCF Analysis is a method for valuing assets using their expected future cash flows. The core of DCF analysis is that the value of money today is worth more than the same amount in the future due to its potential earning capacity.

This analysis is helpful for people or organisations that are considering acquiring a company or buying securities.

Steps in DCF Analysis

The following are the steps which are used for conducting a DCF Analysis-

• Estimating future cash flows, usually of 5-10 years, with the help of the company's current and previous financial statements.
• Determining the discount rate. The discount rate typically used is the company's weighted average cost of capital (WACC), which reflects the average rate of return required by the company's investors.
• Calculating the present value of cash flows.

Advantages and Disadvantages

Some of the strengths of DCF Analysis are-

• DCF analysis emphasises a company's intrinsic value based on its fundamental financial performance, such as cash flow generation, revenue growth, and profitability.
• DCF allows investors to adjust critical assumptions and variables to see how changes impact the valuation.

Weakness of DCF Analysis are-

• One of the main drawbacks of DCF Analysis is it is based on estimates rather than factual numbers.
• Future cash flows depend on various factors, such as market demand, the status of the economy, technology, competition, and unforeseen threats or opportunities. These can only be quantified partially.

 

#2 - Dividend Discount Model (DDM)

DDM is an analysis based on the theory that a company's current price is worth the sum of all its future dividend payments when discounted back to its present value. The dividend discount model (DDM) is a quantitative method for predicting the price of a company's stock based on the theory that its present-day price is worth the sum of all its future dividend payments.

Steps in DDM Calculation

Following are the steps which are used in DDM Calculation -

• Estimating future dividends
• Determining the discount rate
• Calculating the present value of dividends

Advantages and Disadvantages

Some of the strengths of DDM Analysis are-

• DDM directly values the cash returns to shareholders, making it straightforward for dividend-paying stocks.
• It is simple to apply and understand.

Weakness of DDM Analysis are-

• DDM does not apply to companies that do not pay dividends or have irregular dividend policies.
• DDM focuses only on dividends and sometimes may overlook other important factors such as earnings growth, reinvestment opportunities, and market conditions.

 

#3 - Comparable Company Analysis (CCA)

This method is used mainly when valuation using other models is not possible. This model compares the stock's price multiples to a benchmark to determine whether the stock is underpriced or overpriced. Comparable company analysis is the process of comparing companies based on similar metrics to assess their enterprise value.

Steps in CCA

Following are the steps which are used in CCA -

• Selecting comparable companies means choosing companies with similar metrics or organisations in similar industries.
• Collecting financial data from comparable companies.
• Calculating and applying multiples to the target company. Some of the common multiples include-

EBITDA- Enterprise value divided by earnings before interest, taxes, depreciation, etc.

Price to Sales Ratio- Market price per share divided by sales per share.

Advantages and Disadvantages

Some of the strengths of CCA are-

• CCA is market-driven and reflects the market conditions and sentiments.
• This method is easy to understand and straightforward, making it accessible to broader investors.

Weakness of CCA Analysis are-

• It requires an accurate selection of comparables, as any bias while choosing comparable companies can affect the results.
• The comparables are selected based on assumptions that they are comparable, which may or may not be the case.

#4 - Price-to-Book (P/B) Ratio

The P/B ratio measures the market value of a company's stock against its book. This ratio helps evaluate companies with significant tangible assets, such as financial institutions and manufacturing firms.

The formula for P/B Ratio is P/B = Market Price per Share / Book Value per Share where:

• Market Price per Share: The current trading price of the company's stock.
• Book Value per Share is the company's total assets minus its total liabilities divided by the number of outstanding shares.

Advantages and Disadvantages

Some of the strengths of Price the book ratio are-

• It is helpful for asset valuation.
• The price-to-book ratio is easy to use and apply.

Weakness of the P/B Ratio are-

• It may not capture intangible assets such as patents, trademarks, and goodwill,
• The P/B ratio varies widely across different industries, making it less useful for comparing companies in other sectors.

#5 - Price-to-Earnings (P/E) Ratio

The Price-to-Earnings (P/E) ratio is one of the most commonly used methods for valuing a company's stock. It measures the relationship between a company's current share price and earnings per share (EPS).

The formula of P/E Ratio is P/E = Market Price per Share / Earnings per Share (EPS) where:

• Market Price per Share: The current trading price of the company's stock.
• Earnings per Share (EPS): The company's net income divided by the number of outstanding shares.

Advantages and Disadvantages

The advantages of the P/E Ratio are-

• It is simple to apply.
• Different organisations widely recognise it.
• The P/E ratio reflects investor expectations and sentiment about a company's future growth and profitability.

Some of the weaknesses of the P/E Ratio are-

• It can be misleading if earnings are volatile.
• P/E ratios can vary widely between sectors, making it less useful for comparing companies across different industries.
• The P/E ratio does not consider other important factors such as a company's debt levels, cash flow, or asset base.

Conclusion

There is no single evaluation method that fits all situations. But with the help of this blog, you are now well aware of the characteristics of all five valuation methods and their pros and cons. While a valuation method such as DCF helps value assets using their expected future cash flows, a CCA valuation method compares companies with similar companies to get the valuation. 

These methods can be applied in real-world investing and provide a quick and intuitive way to compare valuations. At NIWS, we aim to equip our students with all the stock market-related methodologies, tips, and tricks curated by experts from their experience! 

Want to discuss the details? We are just a call away! Contact our experts now to learn more.