There are a number of different stock valuation methods that are used by investors and traders alike. Each method comes with its own advantages and disadvantages, so finding the right model for yourself involves some trial and error.
We will break down the most commonly used stock valuation methods; from relative valuation methods through to absolute valuation methods, and wrapping up with some of the key stock terminology for beginners that will help you decipher the charts you see on every trading platform!
Stock Valuation Methods Fall Into Two Main Camps – Absolute & Relative
There are two main ways that people value stocks, which are the absolute valuation models, and the relative valuation models. We are going to break these out for you below.
Absolute Valuation Models
Absolute valuation models are based on the premise that a stock is worth the present value of all future cash flows it is expected to generate. The most popular absolute valuation model is the discounted cash flow (DCF) model.
The DCF model calculates the value of a stock as the present value of all its future cash flows. In other words, it discounts the expected future cash flows back to their present value using a required rate of return. The required rate of return used in the DCF model is typically the cost of equity, which is estimated using the Capital Asset Pricing Model (CAPM).
The CAPM states that the required rate of return on a stock is equal to the risk-free rate plus a risk premium. The risk-free rate is the return on a risk-free investment, such as a government bond. The risk premium is the additional return that investors require to compensate them for taking on the risk of investing in a stock.
The DCF model can be used to value both equity and debt. When valuing equity, the cash flows used in the model are expected future dividends and the terminal value. The terminal value is the present value of all future cash flows beyond the forecast period. It is often estimated using a multiple of earnings or book value.
When valuing debt, the cash flows used in the model are expected future interest payments and the principal repayment at maturity. The discount rate used in this case is the yield to maturity of the bond.
The DCF model is a powerful tool, but it has its limitations. One of the main limitations is that it relies on estimates of future cash flows, which can be difficult to predict accurately. Additionally, the model does not take into account certain important factors, such as the timing of cash flows and the riskiness of those cash flows.
Despite its limitations, the DCF model is still commonly used by analysts to value stocks. When estimating the required rate of return, analysts often use a range of values rather than a single number to account for uncertainty. And when making forecasts of future cash flows, analysts will typically use conservative assumptions to account for the possibility that actual results may fall short of expectations.
Relative Valuation Methods
Relative valuation methods value a stock based on its relative price rather than its intrinsic value. The most common relative valuation method is the price-earnings (P/E) ratio.
The P/E ratio is calculated by dividing a stock’s price by its earnings per share (EPS). It is used to compare the valuation of one stock to another. A high P/E ratio indicates that a stock is expensive relative to its earnings, while a low P/E ratio indicates that it is cheap.
Other popular relative valuation methods include the price-to-book (P/B) ratio and the enterprise value-to-sales (EV/S) ratio.
The P/B ratio compares a stock’s price to its book value, which is the accounting value of a company’s assets minus its liabilities. The EV/S ratio compares a stock’s market value to its sales.
Relative valuation methods are useful for comparing the valuation of similar companies. However, they have their limitations. One of the main limitations is that they do not take into account a company’s future prospects. As a result, they may over- or under-value a company that is expected to experience significant changes in earnings or sales.
Another limitation of relative valuation methods is that they only work when there are comparable companies available for comparison. This can be a problem when valuing companies in niche markets or new industries.
Despite their limitations, relative valuation methods are still widely used by analysts. When using these methods, it is important to compare companies that are similar in terms of size, growth prospects, and profitability.
Stock Terminology For Beginners
When you trade stocks, and you’ll come across a lot of specialized terminology. From EPS, ROE, TTM and EPS growth, through to many other terms, there are plenty that you will want to have at least a basic understanding of what these metrics are showing you. Here are some key terms you need to know:
EPS – This is short for earnings per share, and is a key metric used to value stocks. It tells you how much profit a company has made per share of stock over a certain period of time, typically the last 12 months.
ROE – This is short for return on equity, and measures how well a company is using the money that shareholders have invested in it. A high ROE indicates that a company is generating good returns on the money that investors have put in.
TTM – This stands for trailing twelve months, and refers to the last 12 months of data available for a particular stock. TTM data is useful when looking at things like EPS and ROE, as it gives you the most up-to-date information available.
EPS growth – This is a measure of how much EPS has grown (or shrunk) over a certain period of time, typically the last 12 months. A company with strong EPS growth is usually one that is doing well and is likely to see its stock price rise.
P/E ratio – This is short for price-to-earnings ratio, and is a measure of how expensive a stock is. A higher P/E ratio indicates that a stock is more expensive, while a lower P/E ratio means it is cheaper.
Dividend yield – This tells you how much income you can expect to receive from owning a particular stock, in the form of dividends. A higher dividend yield indicates that a stock is a better income investment.
Payout ratio – This is the percentage of a company’s earnings that are paid out to shareholders in the form of dividends. A higher payout ratio indicates that a company is paying out more of its profits to shareholders, while a lower ratio means that it is retaining more of its earnings.
EBITDA – This is short for earnings before interest, taxes, depreciation, and amortization. It is a measure of a company’s profitability that excludes these items.
These are just some of the key terms that you need to know when valuing stocks. While there are many other metrics and ratios that you can use to find the best stocks out there, these are the most important ones to understand. By knowing what they mean, you’ll be able to make better-informed decisions when buying and selling stocks.