Stock Valuation Essay Sample
When seeking to calculate out which rating method to utilize to value a stock for the first clip. most investors will rapidly detect the overpowering figure of rating techniques available to them today. There are the simple to utilize 1s. such as the comparable method. and there are the more involved methods. such as the discounted hard currency flow theoretical account. Which one should you utilize? Unfortunately. there is no 1 method that is best suited for every state of affairs. Each stock is different. and each industry sector has alone belongingss that may necessitate changing rating attacks. The good intelligence is that this article will try to explicate the general instances of when to utilize most of the rating methods.
Two Classs of Valuation Model.
Evaluation methods typically fall into two chief classs: absolute and comparative rating theoretical accounts. Absolute rating theoretical accounts attempt to happen the intrinsic or “true” value of an investing based merely on basicss. Looking at basicss merely intend you would merely concentrate on such things as dividends. hard currency flow and growing rate for a individual company. and non worry about any other companies. Valuation theoretical accounts that fall into this class include the dividend price reduction theoretical account. discounted hard currency flow theoretical account. residuary income theoretical accounts and asset-based theoretical accounts. In contrast to absolute rating theoretical accounts. comparative rating theoretical accounts operate by comparing the company in inquiry to other similar companies. These methods by and large involve ciphering multiples or ratios. such as the price-to-earnings multiple. and comparing them to the multiples of other comparable houses. For case. if the P/E of the house you are seeking to value is lower than the P/E multiple of a comparable house. that company may be said to be comparatively undervalued. By and large. this type of rating is a batch easier and quicker to make than the absolute rating methods. which is why many investors and analysts start their analysis with this method.
Let’s take a expression at some of the more popular rating methods available to investors. and see when it is appropriate to utilize each theoretical account. ( For related reading. see Top Thingss To Know For An Investing Banking Interview. )
Dividend Discount Model ( DDM )
The dividend price reduction theoretical account ( DDM ) is one of the most basic of the absolute rating theoretical accounts. The dividend theoretical account calculates the “true” value of a house based on the dividends the company pays its stockholders. The justification for utilizing dividends to value a company is that dividends represent the existent hard currency flows traveling to the stockholder. therefore valuing the present value of these hard currency flows should give you a value for how much the portions should be deserving. So. the first thing you should look into if you want to utilize this method is if the company really pays a dividend. Second. it is non plenty for the company to merely a wage dividend ; the dividend should besides be stable and predictable. The companies that pay stable and predictable dividends are typically mature blue-chip companies in mature and well-developed industries. These type of companies are frequently best suited for this type of rating method. For case. take a expression at the dividends and net incomes of company XYZ below and see if you think the DDM theoretical account would be appropriate for this company: | 2005| 2006| 2007| 2008| 2009| 2010|
Dividends Per Share| $ 0. 50| $ 0. 53| $ 0. 55| $ 0. 58| $ 0. 61| $ 0. 64| Net incomes Per Share| $ 4. 00| $ 4. 20| $ 4. 41| $ 4. 63| $ 4. 86| $ 5. 11| In this illustration. the net incomes per portion are systematically turning at an mean rate of 5 % . and the dividends are besides turning at the same rate. This means the firm’s dividend is consistent with its net incomes tendency which would do it easy to foretell for future periods. In add-on. you should look into the payout ratio to do certain the ratio is consistent. In this instance the ratio is 0. 125 for all six old ages which is good. and makes this company an ideal campaigner for the dividend theoretical account. ( For more on the DDM. see Diging Into the Dividend Discount Model. )
Discounted Cash Flow Model ( DCF )
What if the company doesn’t pay a dividend or its dividend form is irregular? In this instance. travel on to look into if the company fits the standards to utilize the discounted hard currency flow theoretical account. Alternatively of looking at dividends. the DCF theoretical account uses a firm’s discounted future hard currency flows to value the concern. The large advantage of this attack is that it can be used with a broad assortment of houses that don’t pay dividends. and even for companies that do pay dividends. such as company XYZ in the old illustration. The DCF theoretical account has several fluctuations. but the most normally used signifier is the Two-Stage DCF theoretical account. In this fluctuation. the free hard currency flows are by and large forecasted for five to ten old ages. and so a terminal value is calculated to account for all the hard currency flows beyond the forecast period. So. the first demand for utilizing this theoretical account is for the company to hold predictable free hard currency flows. and for the free hard currency flows to be positive. Based on this demand entirely. you will rapidly happen that many little high-growth houses and non-mature houses will be excluded due to the big capital expenditures these companies by and large face.
In this snapshot. the house has produced increasing positive operating hard currency flow. which is good. But you can see by the high degree of capital outgos that the company is still puting a batch of its hard currency back into the concern in order to turn. This consequences in negative free hard currency flows for four of the six old ages. and would do it highly hard or impossible to foretell the hard currency flows for the following five to ten old ages. So. in order to utilize the DCF theoretical account most efficaciously. the mark company should by and large hold stable. positive and predictable free hard currency flows. Companies that have the ideal hard currency flows suited for the DCF theoretical account are typically the mature houses that are past the growing phases. ( To larn more about this method. see Taking Stock of Discounted Cash Flow. ) Comparables Method
The last method we’ll expression at is kind of a catch-all method that can be used if you are unable to value the company utilizing any of the other theoretical accounts. or if you merely don’t privation to pass the clip scranching the Numberss. The method doesn’t effort to happen an intrinsic value for the stock like the old two rating methods do ; it merely compares the stock’s monetary value multiples to a benchmark to find if the stock is comparatively undervalued or overvalued. The principle for this is based off of the Law of One Price. which states that two similar assets should sell for similar monetary values. The intuitive nature of this method is one of the grounds it is so popular.
The ground why it can be used in about all fortunes is due to the huge figure of multiples that can be used. such as the price-to-earnings ( P/E ) . price-to-book ( P/B ) . price-to-sales ( P/S ) . price-to-cash flow ( P/CF ) . and many others. Of these ratios though. the P/E ratio is the most normally used one because it focuses on the net incomes of the company. which is one of the primary drivers of an investings value.
When can you utilize the P/E multiple for a comparing? You can by and large utilize it if the company is publically traded because you need the monetary value of the stock and you need to cognize the net incomes of the company. Second. the company should be bring forthing positive net incomes because a comparing utilizing a negative P/E multiple would be nonmeaningful. And in conclusion. the net incomes quality should be strong. That is. net incomes should non be excessively volatile and the accounting patterns used by direction should non falsify the reported net incomes drastically. ( Companies can pull strings their Numberss. so you need to larn how to find the truth of EPS.
These are merely some of the chief standards investors should look at when taking which ratio or multiples to utilize. If the P/E multiple can non be used. merely expression at utilizing a different ratio such as the price-to-sales multiple.
The Bottom Line
No one rating method is perfect for every state of affairs. but by cognizing the features of the company. you can choose a rating method that best suits the state of affairs. In add-on. investors are non limited to merely utilizing one method. Often. investors will execute several ratings to make a scope of possible values or average all of the ratings into one.
