Valuing stocks can be a tricky business, and it has often been described as more of an art than a science. The value of a stock is not equivalent to its market price; stock valuation estimates how accurately the price of a stock reflects the company’s (future) performance, and can vary as widely as individual investors’ opinions and predictions. Simply put, the value of a stock is a combination of a company’s current value and a projection of its future profits. A company, therefore, may have little actual value at present but have a high stock valuation owing to expected growth in the market. Buying stocks that promise great growth and increased profits in the future is the key to successful stock investment.
The basic tools for assessing the value of a stock are the valuation ratios. These ratios represent a company’s share price to various aspects of the company’s financial performance and are given in the format of: price/earning (P/E), price/sales (P/S), price/cash flow (P/CF), etc. Once you choose the valuation that most interests you regarding a specific company, you then have to decide whether its value is too high or too low. Not all investors will agree on this point and it is not uncommon for two people looking at the same numbers for the same company to arrive to different conclusions concerning the stock’s value. But how do you decide if the value is too low or too high?
There are two basic methods of applying valuation ratios for determining the value of a stock. The most popular method is relative valuation, and it compares the stock’s valuations with the valuations of other stocks in the same sector or with the company’s own historical stock valuations. Keep in mind, however, that not all companies in a sector are created equal and comparing Toyota’s shares, for example, to Cadillac’s is not likely to give you a good gauge of either company’s relative value. When using comparative valuation you need to research your stocks well and understand the factors that may justify the differences in their market price before making a decision on their value.
The second method for valuing stocks is absolute (also called intrinsic) valuation, and focuses only on fundamentals (such as dividends, cash flow, and growth rate) for a particular company, without comparisons to other companies. The most common way to estimate a company’s absolute value is by calculating a company’s current value of its future free-cash flows. Calculating absolute value can be challenging, because it is difficult to forecast how quickly a company’s cash flows will increase, for how long they will keep increasing, and at what percentage of today’s monetary value they should be calculated.
Valuing stock is not an easy business and they best way to go about it to study your stocks carefully and to include many different parameters in your calculations, just as you would do if you were investing your money in a new house or a new car rather than stocks.