What is a Stock Valuation?

A stock valuation is a way to determine the ‘correct’ price for a stock based on the true worth of the company. There are many methods to determine a stock’s valuation, and they range from fairly simple to extremely complex. Most methods fall into one of two main categories: absolution valuation and relative valuation.

Absolute Valuation

Absolute valuation methods try to find the true, or intrinsic, value of a company and, by extension its stock price, based on the company’s fundamentals. Fundamentals include metrics such as dividends, cash flow, and growth rate. Absolute valuation measures the worth of only the company you are looking at, not other companies in the same industry.

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Absolute valuation methods can be complex. A popular absolute valuation method is the dividend discount model , which uses the stock’s anticipated dividends and discounts them back to the current price. This method can only be used for stocks that pay a dividend. For non-dividend-paying stocks, you can use the discounted cash flow method which estimates a company’s future cash flow and discounts the present share price for that metric.

Relative Valuation

Relative valuation methods use metrics that can be compared to other companies that are similar. Relative valuation models look at things like the company’s price-to-earnings ratio, also called the P/E ratio. This is calculated by dividing the stock price by the annual earnings per share. If the subject company has a P/E ratio that is lower than the P/E ratio of other firms of comparable size in the same or similar industries, the subject company is considered to be undervalued, and its stock would be considered a good investment.

To determine the P/E ratio, divide the company’s stock price by its earnings per share over the last 12 months. For example, a stock that is trading at $22 per share, with earnings per share over the past twelve months of $2 per share would have a P/E ratio of 11. (22 divided by 2 equals 11). If other comparable companies have P/E ratios of 18, 15, and 12, the stock you are looking at would be the most undervalued of the four, and therefore its stock would be the best investment of the group.

Using a Stock’s Valuation to Make Investing Decisions

Regardless of the method you choose, the idea behind calculating a stock valuation is to determine if the stock is fairly valued. Understanding a stock’s valuation lets you compare the intrinsic value of the stock to the current stock price. If you calculate a stock’s valuation to be $50 per share and it is selling at $45 per share, that stock represents a good buying opportunity. If you own a stock whose value you have calculated at $50 per share and it is trading at $55 per share, you may want to consider selling. Market theory says that eventually the stock will get back to its intrinsic value.

Stock prices go up and down depending on what investors believe will happen in the future, so a stock can be undervalued or overvalued on any given day. The secret to successful investing is to buy stocks that are undervalued and sell them when they are overvalued – the common ‘buy low, sell high’ philosophy. That is the basis of investing in the stock market.