What’s It Worth:
How Stocks Are Valued
Stock valuations underlie most analyst recommendations about which securities they should buy or sell. But different valuation methodologies can result in different valuations, so it helps to know the different approaches used.
What is a stock’s true value? This question has challenged equity investors and analysts since stocks were first traded. At the core of any buy or sell recommendation lies some estimate of the stock’s intrinsic value — what it should be worth. But analysts calculate this value many different ways, employing different methodologies and taking into consideration a multitude of different qualitative and quantitative factors that can result in wide disparities.
While there is no “right” way to value a stock, certain valuation techniques can be more valid in some cases. A growth-oriented investor, for instance, may place greater weight on a company’s earnings growth potential, while a value-oriented investor may place greater emphasis on a stock’s valuation relative to its peers.
Three of the most widely used approaches to security valuation are net present value, the dividend discount model, and multiplier analysis. We’ll focus on multiplier analysis because it is the most widely used.
Looking at a stock’s price as a multiple of its earnings, revenues or assets is the most commonly used valuation metric among analysts and investors. Analysts will typically scrutinize the results of these ratios to examine how investors are currently pricing a publicly-traded company, noting how these multiples compare to industry peers, benchmark indices and market levels.
• The price-to-earnings ratio, or P/E, is by far the most widely used valuation metric. It indicates how much investors are currently willing to pay for each dollar of the company’s recent, current or estimated earnings.
• The price-to-sales ratio (P/S) indicates how much the market is willing to pay for each dollar of sales. It is derived by dividing a company’s total market value (stock price times number of shares outstanding) by its yearly revenues. Investors will often use this approach when companies have not recorded a profit. The logic is that if sales are strong and growing, and the company is otherwise healthy, earnings may be just around the corner. Value investors, on the other hand, look for low price to sales ratios for stocks for companies that may have been unwittingly thrown on the scrap heap.
• The price-to-book value ratio (P/B) is the result of dividing market capitalization by book value, also known as shareholder equity. Book value represents the company’s theoretical liquidation value, if the company shut down operations, paid off its debts and sold off its assets. As such, the usefulness of book value as a valuation tool depends significantly on the industry. It is particularly relevant in capital intensive businesses.
Use the Entire Tool Kit
In practice, investors will consider several different valuation approaches and then look at a variety of other information before arriving at a final value. They will try to determine whether a company is fundamentally sound by scouring public reports (10-Ks, 10-Qs, Annual Reports) examining industry trends and understanding the regulatory and market environments, among many other things. They will also consider technical factors such as the stock’s trading history and trends. Ultimately, the “final” valuation will consider a multitude of factors, which may vary widely from analyst to analyst, and is ultimately up to the market’s judgment.
Company Valuation Analysis
Analysts use multiple criteria for valuing a company, including:
Intrinsic Value Analysis
o Determines the security’s “intrinsic value” based on discounted “free” cash flow (DCF) analysis.
o Includes estimates of future “free” cash flows that are discounted back to current dollars, including variables such as risk assessment and capital structure.
o Looks at present value of shares vs. current share price.
o Considers 10-15 year projection.
o Defines parameters around DCF to make it more reasonable (e.g. interest rate inputs)
o Assesses a security’s relative value by comparing appropriate financial ratios across peer groups and industry group.
o Reviews company value metrics, including P/E trading history, high/low in cycle and current P/E level justification.
o Compares valuation vs. appropriate index.
Sum of Parts
o Attempts to quantify “fair value” of a stock by determining private market values for a firm’s individual units.
o Breaks divisions up as stand-alone business units.
o Calculates a relative value for each division.
o Arrives at a blended valuation.
o Examines technical risk, which involves analysis of market trends and patterns rather than an exclusive focus on company fundamentals.
o Evaluates insider buying, which may indicate whether company executives or employees believe their stock is undervalued.
o Quantifies “beta,” a measure of the volatility of a stock’s price relative to the general market.
No matter what your investment goals may be, a systematic process for stock selection can help take the emotions of your decision making. With that in mind, let me assist you in developing a process that will help determine which stocks to buy or sell and how to manage your overall portfolio.
If you’d like to learn more, please contact Irene F. Stolarz.
Equity Securities’ prices may fluctuate in response to specific situations for each company, industry, market conditions, and general economic environment.
Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.
Companies paying dividends can reduce or cut payouts at any time.
Article by McGraw Hill and provided courtesy of Morgan Stanley Financial Advisor.
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