Stock valuation estimates what a company is truly worth. By comparing this intrinsic value to market price, you can identify potentially undervalued or overvalued stocks.
Why Valuation Matters
Purpose
Valuation Helps:
- Determine fair price
- Find undervalued stocks
- Avoid overpaying
- Make informed decisions
Price vs Value
Key Distinction:
- Price: What you pay
- Value: What you get
- Goal: Pay less than value
Two Main Approaches
Absolute Valuation
What It Does:
- Estimates intrinsic value
- Based on fundamentals
- Independent of market
Example: DCF (Discounted Cash Flow)
Relative Valuation
What It Does:
- Compares to similar companies
- Uses ratios and multiples
- Relative to market
Examples: P/E, P/B, EV/EBITDA
Relative Valuation Methods
Price-to-Earnings (P/E)
Most Common Method
Formula: Stock Price รท Earnings Per Share
How to Use:
- Find company's P/E
- Compare to industry average
- Compare to historical average
Interpretation:
- Below average = potentially undervalued
- Above average = potentially overvalued
Limitations:
- Earnings can be manipulated
- Doesn't work for unprofitable companies
- Growth not fully captured
Forward P/E
Using Future Earnings: Price รท Expected Future EPS
Advantage: Forward-looking
PEG Ratio
Growth-Adjusted P/E: P/E รท Earnings Growth Rate
Interpretation:
- PEG < 1: Potentially undervalued
- PEG = 1: Fairly valued
- PEG > 1: Potentially overvalued
Price-to-Sales (P/S)
Formula: Market Cap รท Revenue
When Useful:
- Unprofitable companies
- Comparing within industry
- Cyclical companies
Price-to-Book (P/B)
Formula: Stock Price รท Book Value Per Share
When Useful:
- Asset-heavy companies
- Financial companies
- Value investing
EV/EBITDA
Formula: Enterprise Value รท EBITDA
Advantages:
- Accounts for debt
- More comprehensive
- Capital structure neutral
Typical Ranges:
- < 10x: Potentially cheap
- 10-15x: Moderate
- > 15x: Expensive
EV/Revenue
Formula: Enterprise Value รท Revenue
When Used:
- Growth companies
- SaaS businesses
- Unprofitable companies
Absolute Valuation Methods
Discounted Cash Flow (DCF)
The Gold Standard
Concept: Company worth = present value of future cash flows
Basic Formula: Value = ฮฃ (Future Cash Flow รท (1 + Discount Rate)^n)
Steps:
- Project future cash flows
- Determine discount rate
- Calculate present value
- Add terminal value
- Sum for total value
DCF Components
Free Cash Flow Projections:
- Usually 5-10 years
- Based on growth assumptions
- Revenue, margins, CapEx
Discount Rate:
- Cost of capital
- Often 8-12%
- Higher for riskier companies
Terminal Value:
- Value beyond projection period
- Often largest component
- Growth or exit multiple method
DCF Challenges
Difficulties:
- Highly sensitive to assumptions
- Small changes = big value changes
- Forecasting is hard
- Garbage in, garbage out
Dividend Discount Model
For Dividend Payers
Formula: Value = Dividend รท (Required Return - Growth Rate)
Example: $4 dividend, 10% required return, 3% growth Value = $4 รท (0.10 - 0.03) = $57.14
Limitations:
- Only for dividend stocks
- Assumes constant growth
- Sensitive to assumptions
Choosing a Method
By Company Type
Growth Companies:
- P/S, EV/Revenue
- PEG ratio
- DCF with high growth
Mature Companies:
- P/E
- Dividend model
- EV/EBITDA
Financial Companies:
- P/B
- P/E
- Specialized metrics
Asset-Heavy:
- P/B
- Asset-based valuation
Use Multiple Methods
Best Practice:
- Don't rely on one method
- Triangulate with several
- More confidence when they agree
Practical Valuation Tips
Margin of Safety
Concept: Buy significantly below estimated value
Why:
- Valuation is imprecise
- Protect against errors
- Improve risk/reward
Example: Calculate value at $100, only buy below $70
Sensitivity Analysis
Test Assumptions:
- What if growth is lower?
- What if margins compress?
- Different discount rates?
Shows: Range of possible values
Historical Comparison
Compare To:
- Company's own history
- What P/E did it trade at?
- Current vs historical
Qualitative Factors
Also Consider:
- Management quality
- Competitive position
- Industry trends
- Growth potential
Common Mistakes
Valuation Errors
Avoid:
- Using single method
- Ignoring context
- Precise false confidence
- Not accounting for risk
- Comparing different industries
Over-Precision
Remember: Valuation is art and science. A range is more realistic than exact number.
Key Takeaways
- Relative valuation compares to peers (P/E, P/B)
- Absolute valuation estimates intrinsic worth (DCF)
- Use multiple methods for better confidence
- PEG ratio adjusts P/E for growth
- EV/EBITDA accounts for debt differences
- DCF is comprehensive but assumption-sensitive
- Apply margin of safety to any estimate
- Valuation is a range, not a precise number
What's Next?
Learn how to analyze company management and corporate governance.
This article is for educational purposes only and does not constitute financial advice.