Question.3251 - Stock Valuation
Answer Below:
“Valuation is regarded as the first step toward intelligent investing”. Valuation in simple terms means calculating the price of any asset as on date which means the worth of an asset/stock from the point of view of investor. Similarly, stock valuation is calculating the estimated market value of particular stocks of companies. No doubt, it is an integral part of the financial world, especially for the ones who trade/ invest regularly in stocks. In the view Sir John Maynard Keynes, “stock valuation is not a prediction but a convention, which serves to facilitate investment and ensure that stocks are liquid, despite being underpinned by an illiquid business and its illiquid investments, such as factories”. In this paper, we shall study the models in which the valuation methodology is conducted and the methods for each of them. Valuation Methodology and Methods: Valuation methodology can be classified into: a) Absolute Valuation Methodology b) Relative Valuation Methodology In the former one, the focus lies on determining the intrinsic value of an investment – means determining the fundamental value of the stock based on the data provided by the company, while the later is more focussed on determining the value of the stock based on the industry standard valuation ratios. These (Relative) are also called as comparable methods. And in absolute methodology the value of stocks or other assets, is based upon the discounted value of their expected future cash flows. Absolute Valuation Methodology includes the most widely used dividend discount model and the discounted cash flow method while the relative valuation methodology includes of price to earnings ratio, price to book value ratio, price to sales ratio and price to cash flow ratio among the most common ones. a) Dividend discount method (DDM):First things first -dividend discount method is valid only for those companies which have a history of paying dividends to their shareholders. The most conservative, model calculates the value of the share based on the dividends it pays to its stockholder. The concept lies that any firm is equal to the present value of the forecasted dividends it is about to pay to its stockholders. The equation used for this model is: P = D1 / r-g Where: P = Price of the stock D1 = Expected dividend for the next year R = Discount rate G = Growth rate of dividends Example: ABC Limited pays a dividend of $10 annually. The required rate of return stands at 10% and the growth rate of dividends is 5%. Price of the stock as per DDM = $10*(1+5%) / (10%-5%) = $210 Points to remember: 1. DDM method cannot be used for companies which do not pay dividend. 2. DDM cannot be used when the rate of return is lower than the rate of growth rate of dividends. 3. DDM can further be bifurcated into single stage discount model, multi stage discount model (where dividends are higher or lower for a particular period and then become stagnant) b) Discounted cash flow method (DCF): While the concept behind lies the same as dividend discount model, the numbers which change here are cash flows instead of dividends. In this model, the price of the stock is determined by discounting the forecasted cash flows of the company at a discount rate to get the present value of them. Similar to DDM, DCF is also the most used valuation methodology for determining price of a stock. Key components of the DCF technique includes: Free Cash Flow, Terminal Value (Value at the end of the Free cash flow projection period) and the Discount Rate. Moving further to the Relative Valuation methodologies, as mentioned above, these ratios use industry comparable to understand or calculate the value of the stock. Relative Valuation doesn’t find the intrinsic value as in the absolute valuation methods rather it focuses on the comparison of share’s price multiples to comparable benchmark. Reason behind that two similar asset ahousl has similar values. This is often referred as “Law of One Price”. The most common ones are discussed below. a) Price to earnings ratio: To calculate this figure we need to divide the price by the earnings (EPS) of the company. This ratio tells us how much an investor is willing to pay for per dollar of earnings. For example, if a company were trading at a P/E ratio of 10, means the investor is willing to pay $10 for $1 of its earnings. We need to notice that this valuation metric is not valid for companies which do not have earnings or negative earnings. b) Price to book value ratio: Here we divide the price by the book value of the asset (total asset – intangible assets and liabilities). Similar to P/E multiple, this ratio uses book value of the comparable stocks to value the price for concerned stock. It is actually a ratio of market value of equity to the book value of equity. c) Price to sales ratio:Another determinant where prices are divided by the sales figure. The ratio is calculated by dividing the company's market cap by the sales figures in the latest year. The above mentioned ratio’s can be read as different for different industries. While a P/E ratio of 20 can be high for one company, it can be considered lower for another company. It depends, which industry the company is serving into. Based on the industry standards, we determine whether the particular share is overpriced or underpriced on the above valuation metrics. Interestingly, all the above methods used for stock valuation can result into different valuation price for a similar stock. Though the facts and figures may be same, but due to the different valuation technique, the price arrived for result could be different. As a result, most of the times, the investor uses a blended valuation technique. In this method, he/she gives weightings to each valuation metric and boils to one price after considering all above. Believe, that’s why valuation is not exactly referred to a science, but considered an art as well. References: John D. V., April 6, 2000, Dividend Discount Model, http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/ddm.htm John H. and Steve H., Chapter 11, Discounted Cash Flow, http://espace.library.uq.edu.au/eserv/UQ:8138/n11__INTRODUCTIO.pdf Jerald E. P, Elaine H. Thomas R. and John D., 2010, Chapter 1 - Equity Valuation: Applications and Process, Equity Asset Valuation. http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/ddm.htm Absolute Valuation, http://news.morningstar.com/classroom2/course.asp?docId=2959&page=5&CN=CMore Articles From Finance
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