Stock Valuation

Estimation of the intrinsic value of a company

Author: Sid Arora
Sid Arora
Sid Arora
Investment Banking | Hedge Fund | Private Equity

Currently an investment analyst focused on the TMT sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a BS from The Tepper School of Business at Carnegie Mellon.

Reviewed By: Adin Lykken
Adin Lykken
Adin Lykken
Consulting | Private Equity

Currently, Adin is an associate at Berkshire Partners, an $16B middle-market private equity fund. Prior to joining Berkshire Partners, Adin worked for just over three years at The Boston Consulting Group as an associate and consultant and previously interned for the Federal Reserve Board and the U.S. Senate.

Adin graduated from Yale University, Magna Cum Claude, with a Bachelor of Arts Degree in Economics.

Last Updated:September 12, 2023

What Is Stock Valuation?

Stock valuation refers to estimating the intrinsic value of a company and comparing the estimated value with the current price of the company's stock to identify undervalued or overvalued shares.

If the stock price is lower than the valuation, it is undervalued, and investors can consider entering the market. Inversely, if the stock price is higher than the valuation, it is overvalued, and they might consider selling the stock.

Stock valuation is a relatively complex process with many factors, and there is no globally uniform standard. There are various methods for valuing stocks based on different perspectives, such as:

  • Investors' expected returns
  • Corporate profitability
  • Corporate asset value

It is often difficult for investors to grasp the underlying laws behind it. On the other hand, from the perspective of a single stock, in the long run, the stock price generally fluctuates around its intrinsic value. 

It is very important to estimate the value of a stock or a listed company through a relatively scientific and reasonable valuation system. 

Generally speaking, various valuation methods measure the value of stocks. Investors must consider the convenience and simplicity of valuation methods, relevant data availability, and valuation models' accuracy. This article will introduce you to some common valuation methods.

Key Takeaways

  • Stock valuation estimates the intrinsic value and compares it to the current stock price to find undervalued or overvalued shares.
  • Two types of valuation methods: Absolute (DDM and DCF) and Relative (P/E and PEG).
  • Absolute methods focus on fundamentals and future cash flows, while relative methods compare to industry peers.
  • Valuation is complex; investors must choose suitable methods based on data and accuracy.
  • Careful analysis is needed for accurate stock valuation.

Types of Stock Valuation

There are two basic types of stock valuation: 

1. Absolute valuation

It mainly analyzes the fundamentals of the company. It estimates the company's past financial reports, operating performance, and the company's forecast of future operating conditions, ultimately obtaining the company's true intrinsic value.

The price of a stock generally fluctuates around the intrinsic value. 

If you find that the stock is undervalued/the price is far below the intrinsic value, buy the stock. When the price of the stock returns to the intrinsic value or is even higher than the intrinsic value, sell.

Compared with the relative valuation method, the advantage of the absolute valuation method is that it can reveal the intrinsic value of the company's stock more accurately. However, it is more challenging to choose the parameters correctly. 

Forecasting errors while calculating future dividends and cash flows, as well as errors in the selection of discount rates, may affect the accuracy of valuations.

The main types of valuation are as follows:

2. Relative valuation

It means there is no absolute reference value, mainly through the comparison between companies in the same industry and then evaluating whether the value of a company is undervalued or overvalued.

The main types of valuation are as follows:

  • Price-to-Earnings Ratio (P/E) Valuation Method
  • Price-to-Earnings Growth (PEG) Valuation Method

Dividend Discount Model (DDM)

The dividend discount model is an absolute valuation method used to evaluate the rationality of the company's current stock price by discounting the company's future dividends.

The formula is:

Stock value = Expected Dividend per Share (EDPS) / (Cost of Capital- Dividend Growth Rate)

The DDM models focus on examining the intrinsic value of the stock. Intrinsic value refers to the value stock should have on its own, not its market price. The intrinsic value of the stock can be evaluated by the sum of the present value of the annual dividend income of the stock.

The dividend is the return given to the shareholders by the joint-stock company that issues the stock, and the profit is distributed according to the shareholding ratio of the shareholders.  

The basis of this valuation method is that if you hold this stock forever, the discounted value of the dividends you get from the company year by year is the stock's value.

If the result is higher than the current stock price, it means that the current stock price is undervalued and has investment potential.

Inversely, if the result obtained after DDM calculation is lower than the current stock price, it means that the stock price is overvalued, signaling that a short position might be wise.

For companies that rarely pay dividends or often lose money and cannot pay dividends, it is difficult to predict the dividend growth rate, so this model is not applicable.

Discounted Cash Flow (DCF)

A discounted cash flow analysis is used to estimate the value of an investment by estimating the future cash flows of the company.

This method calculates the intrinsic value by discounting the future expected cash flows to evaluate whether the company's current stock value has potential investment opportunities.

The discounted cash flow valuation method involves forecasting the future cash flows of the enterprise as well as its risks and then selecting a reasonable discount rate to convert the future cash flow into the present value.

In this case, cash flow refers to the net cash flow after deducting discounts, expenses for maintaining business operations, etc. When the price of a target stock is higher than the discounted present value, it means that the stock price is overvalued and vice versa.

Generally speaking, investors will divide the discounted cash flow valuation of a listed company into two parts, one part is the high-speed growth period in the first 5-10 years, and the other part is the perpetual cash flow after the first 5-10 years.

In general, investors need to have a clear understanding of the future development of the company in order to obtain an accurate DCF value. 

The process of obtaining the DCF value involves judging the future development of the company.

For example, when calculating the DCF value of a listed company in the next 5 to 10 years, it is necessary to calculate its reasonable stock price value under various optimistic, neutral, and pessimistic assumptions.

Overall, the main advantage of the DCF valuation method is that it is very rigorous and scientific in measuring the intrinsic value of a listed company or a stock.

In practical applications, it is suitable for listed companies with simple business, stable growth, bright prospects, less capital expenditure, and stable cash flow.

On the other hand, since the DCF valuation method has a lot of assumptions, the valuation models can use for the valuation of companies with different fundamental types, different industries, and different growth cycles.

Price-to-Earnings Ratio (P/E) Valuation Method

The formula for the price-to-earnings Ratio (P/E) valuation method is as follows: 

(P/E) = share price ÷ (EPS)

The price-earnings ratio refers to the ratio of the price per share to the earnings per share of a listed company's stock.

It is the most commonly used valuation method in the market to assess whether the stock price is undervalued or overvalued.  

If the current price-earnings ratio is the only tool used to judge whether a stock's price is high or cheap, there is a high likelihood that any conclusions made will not be entirely accurate.

The value of earnings used in the formula generally uses the EPS data from the most recent full fiscal year, while the value of the price is the latest stock price of the target stock.

As a valuation method that has been practiced for a long time in the stock market, the most prominent feature of the price-earnings ratio valuation method is that it is very simple and effective.

Simply put, if a listed company's earnings per share are constant for several years into the future, then the PE value can be used to calculate how many years it will take the shareholders of the listed company to recover their initial investment (without calculating the time value of money).

It should be pointed out that it is almost impossible for the vast majority of listed companies to maintain constant earnings per share for multiple years. 

Therefore, the changes in earnings often depend on the macroeconomic environment, the life cycle of the company, and the operation and management situation. With a variety of other factors, the future annual earnings per share face great uncertainty.

The price-earnings ratio valuation method is only an approximate estimate of the value of a stock. It can only roughly measure whether a stock is overvalued, undervalued, or accurately valued at the current price-earnings ratio.

The main disadvantage of historical price-earnings ratio valuation is that it cannot fully reflect the changing situation of a stock's future fundamentals.

For example, some highly cyclical companies have their lowest price-earnings ratio at the peak of the cycle, and the stock price at this time is often near the 52-week high.

Price-to-Earnings Growth (PEG) Valuation Method

The formula for the price-to-earnings growth (PEG) valuation method is as follows:

Price-to-Earnings Growth Ratio = Price-to-Earnings Ratio (P/E) ÷ Earnings Growth Rate

The price/earnings growth ratio (PEG) refers to the value obtained by dividing the price-earnings ratio of the listed company by the growth rate of earnings.

It is an indicator used to assess whether the current share price of a growing company is reasonable.

Generally, when the price-earnings growth ratio is calculated as 1, the stock price is judged to be at a reasonable price; when the PEG is greater than 1, it means that the stock price is overvalued; and when the PEG is less than 1, it means the stock is undervalued.

However, it is difficult to accurately predict future earnings growth rates. Everyone's judgment may be different, and from the perspective of the company's past profitability, there is no guarantee that it will continue to be maintained in the future. 

Therefore, it is still necessary to comprehensively evaluate the results of multiple indicators in order to more effectively grasp the rationality of stock prices.

The PEG valuation method can not only examine the current performance of a listed company through the price-earnings ratio but also examine the company's growth expectations in the future through the earnings growth rate.

The disadvantage of this valuation method is that the PEG valuation method may not be suitable for companies whose earnings growth rate is too low or too high.

Moreover, for stocks with different industries, different cycles, and fundamentals with greater specificity, overvaluation or undervaluation is difficult to determine, requiring investors to grasp these variables at a deeper level.

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

Researched and authored by Yiqing QiaoLinkedIn

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