How is stock valuation done? Methods of stock valuation

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Anyone who wants to outperform the market, in the long run, must learn how to value stocks accurately. To put it simply, stock valuation is a way of determining a stock's "inner value." A stock's intrinsic worth isn't tied to its current price, making stock valuation important. An investor can assess if a stock is overvalued or undervalued based on its inherent worth.

Valuation of stocks

Valuing stocks is exceedingly complex and may be considered a blend of both science and art. It can be difficult for investors to sort through all of the information that might be utilized in evaluating stocks (such as corporate financials, economic data, stock reports) because of the sheer volume.

As a result, a successful investor must separate useful information from irrelevant fluff. Investors should also be familiar with the most common techniques for valuing stocks, as well as the situations in which they might be used.

Stock valuation types.

Stock valuation methodologies fall into two basic categories: absolute and relative.

1. Absolute

Absolute stock value is based on fundamental information about the company. For the most part, this approach requires an examination of a company's financial statements and the information contained within. Many absolute stock valuation approaches focus on the company's cash flows, growth rates, and dividends. The discounted cash flow model (DCF) and the dividend discount model (DDM) are two of the most often used absolute stock valuation approaches.

2. Relative

The concept of relative stock valuation is based on comparing an investment to other investments in the same industry. When using the relative stock valuation technique, financial ratios from similar firms are compared to the target company's financial ratios. Comparable company analysis is the best illustration of relative stock valuation.

Stock Valuation Methods

We'll go over some of the most common methods of stock valuation.

  1. Dividend Discount Model (DDM)

When it comes to stock valuation, dividend discounting is an essential tool. Dividends are assumed to represent the company's net cash flow, where the DDM comes in.

According to the model, the intrinsic value of a company's stock is equal to the current value of the company's expected future dividends. It is important to note that the dividend discount method is only relevant when a company consistently delivers a fixed amount of dividends and the dividend distribution is consistent.

2. Discounted Cash Flow Model (DCF)

Another prominent stock valuation approach is the discounted cash flow model. The intrinsic stock value is determined by discounting the firm's free cash flows to their present value via the DCF method.

To put it differently, the DCF method does not consider assumptions about dividend payments. Thus, it is excellent for companies with uncertain dividends. However, from a technical standpoint, the DCF model is sophisticated.

3. Comparable Companies Analysis

According to the comparable technique, a stock's potential price can be calculated by comparing the stock's price multiple to that of similar companies.

Three typical multiples include the P/E ratio (price to earnings), EV to EBITDA, and price to book (P/B). Technically, comparing a company's technique is one of the most straightforward. However, the most challenging component of the comparison process is determining which genuinely comparable companies.

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