What Is Stock Valuation?

Stock valuation is the single most crucial skill that investors need to master to determine if
a stock is currently overpriced or underpriced concerning a company’s performance and
growth projections.
Stock valuation is a critical measure of calculating fair value. It allows investors to perform
a comparative study of stocks to learn, which can grow in the long run.

Types Of Stock Valuation

There are two primary types of stock valuation methods: Absolute and Relative.

• Absolute
The absolute method of stock valuation relies on the fundamental analysis of a business. It
bases valuation on various financial information derived from financial statements, focusing
on metrics like cash flow, dividend, and growth rate.
Calculating a stock’s value using the absolute method involves computation of dividend
discount model (DDM), discounted cash flow model (DCF), residual income model, and
asset-based model.
Absolute method, as the name suggests, doesn’t compare the company’s performance with
peers.

• Relative
The relative valuation method involves comparing significant financial ratios of similar
companies and deriving the same metrics for the company in focus. The popular way is
comparable companies analysis.
Calculating the P/E ratio forms the cornerstone of the relative valuation method. For
instance, if the P/E ratio of the current company is less than its peer, then its stocks are
undervalued.
Let’s understand with an example. Company A reported diluted earnings per share for the
fiscal ending in January 2021 as Rs 6.76 and price at the time of calculation, Rs 203. To
obtain a P/E ratio, we will divide the share price by EPS.
P/E = (Rs 203/ 6.76) = Rs 30.03.
One can easily obtain EPS value from a company’s financial statements and price is the
current value of its shares in the market.

Common Stock Valuation Methods

Let’s now see what popular stock valuation methods you can apply.

• Dividend Discount Model (DDM)

The dividend discount model is an accepted method for calculating the absolute value of a
stock. It calculates the actual price based on the dividends the company pays to its
shareholders. Analysts argue that dividends represent the genuine cash flow of the business
going to its shareholders, and calculating the present value of future dividend payment
should give the correct worth of the stock.
Large corporations, which pay regular dividends at a stable rate are best suitable for DDM
valuation. Next, investors apply the GGM or Golden Growth Model, assuming a predictable
dividend growth rate. It is a straightforward method and takes away the complications of
variable dividend payout.

• Discount Cash Flow Model (DCF)

When a company doesn’t pay a dividend or has an irregular dividend model, investors use a
discounted cash flow model, which bases its calculation on discounted future cash flow
instead of dividend rate.
The discounted cash flow model can be applied to a wide range of companies that are not
blue-chip, including those which don’t pay any dividend.
There are several ways available to calculate DCF. However, the most popular is the two-
stage DCF model, where investors first calculate free cash flow forecasted for five to ten
years and then measure terminal value for all the cash flows beyond the forecasted period.
To efficiently calculate valuation based on the DCF model, companies must have stable and
predictable free cash flow. Thus, mature companies past the growth stage are considered
the ideal candidates for DCF valuation.

• The Comparable Analysis

The comparable analysis compares different crucial financial ratios between companies to
determine the true worth of stocks. It includes comparing values like the P/E ratio, price to
book ratio, and EBITDA. It is based on the ‘law of one price’ principle, which proposes that
two similar assets should have the same price, deviation from this fundamental suggests
undervaluation or overvaluation.
A comparable analysis is one of the simplest methods of stock valuation that anyone can
apply.
Comparing the P/E ratio forms the cornerstone of stock valuation. P/E ratio represents the
company’s stock price divided by the most recent reported earning per share (EPS). A low
P/E ratio makes a stock attractive to investors.

• P/E Ratio Forms The Basis of Stock Valuation Theory

The most common way of valuing a stock is by calculating the price-to-earnings ratio. The
P/E ratio is a valuation of a company’s stock price against the most recently reported
earnings per share (EPS). Investors use the P/E ratio as a yardstick to measure a
company’s stock value. A higher P/E ratio would imply overvalued shares. Conversely, a low
P/E, when compared against peers and the broader market, indicates undervalued shares.
Value investors constantly look for undervalued shares with potential for long-term growth.
Analysts review the P/E ratio to determine if the price per share accurately represents
projected earnings per share. Often the EPS used in calculating the P/E ratio is P/E (TTM),
where TTM is trailing 12 months or income of the company in the past twelve months.
References:
One, A. (2023). What is Stock Valuation, Types & Methods?
https://www.angelone.in/blog/what-is-stock-valuation