Valuation is a method of determining how much an asset or company is worth. Market value (Market capitalization), on the other hand, is simply the number of outstanding shares multiplied by the current share price (i.e. the buyer-willingness to pay a particular amount for the stock).
The valuation of a stock is based on: (Valuation does not refer to actual market price of the stock)
- Earnings of the company
- How well the company is expected to perform in the future
- How well it is performing in terms of other similar firms
- Free cash flow to the firm (FCFF) - this represents the net amount of cash that a firm generates after expenses, taxes, and any changes in operating and investing activities carried out by the firm
To understand this better, let’s take a scenario where we have a Stock A and we want to see if the current stock price ($10) accurately reflects the company’s value or performance on other indicators. If the stock belongs to the technology sector, we will refer to its Financial Statements and analyze the products it manufacture, the innovations it has carried out in recent times, it's ability to generate profits, the effectiveness of the management and their ability to take up new projects, and research and development (R&D) for new revenue sources.
All these cover both qualitative and quantitative factors which would help us determine what the company is worth and how well "Stock A" is placed in the sector. Valuation helps in making sure that you invest in a financially strong company rather than going for a fake firm with escalated profits or cooked books (financial statements are often manipulated by the management to provide a fake picture to its investors).
There are several methods to value a stock which helps an investor in make sound investments and not be fooled by following herd mentality or making investments in falsely lucrative stocks (stocks which escalate its price without any strength in its financials). The following methods are the most commonly followed valuation techniques:
- Discounted Valuation Method: Analysts determine the future value of a company by discounting cash flows, dividends or earnings. When cash flows are discounted for its present value, it is known as Discounted Cash Flow Method (DCF), the same with dividends is Dividend Discount Method (DDM). The company's performance is measured based on some underlying factors such as dividends, income, cash flows etc — this is it's intrinsic value. It is divided by the total number of shares to reach at a stock target price.
Target Price = Intrinsic Value/ Total No. of Outstanding Shares
- Residual Income Model: This approach measures the equity valuation in excess of a threshold level (also known as an Equity Charge) established as a norm by the company or industry as a whole. The residual income (RI) is calculated by subtracting Equity Charge from its Net Income, accounting for a minimum required rate of return.
For example, if Amazon (AMZN) made a Net Income (Profit at the end of year) of $200,000 and during its 3rd quarter earning the company decides to finance its equity by $950,000 at the rate of 12%.
The Equity Charge in this case is $950,000 *12% = $114,000
Residual Income = $200,000 - $114,000 = $86,000
Hence when the cost of equity is included in relation to shareholder’s return, the company above can be seen to make a profit. The future residual income is further discounted to current levels and a target price is calculated.
Enterprise value (EV) measure a company’s total value and is a more reliable method than market capitalization (Market Cap = Total Number of Shares * Current Stock price). EV takes into account market cap, debt, interest and other factors to provide a wholesome figure. EV multiples are a great way to analyze a stock price in comparison with other similar firms. Popular multiples are EV/EBITDA (EV/Earnings before Interest, Taxes, Depreciation and Amortization), and EBIT (EV/Operating Profit). These multiples are used as relative valuation multiple for firms with similar market size and operating in the same industry as the target firm.
Enterprise value is usually calculated as follows:
EV = Market Cap + Market Value of Debt + Minority Interest + Cash -Investments
Similar to Enterprise Multiple, price multiples also help in analyzing a firms valuation in accordance with similar firms in the same industry. Examples of this type are Price-to-earnings (P/E), Price-to-book value (P/B), Price-to-sales (P/S) etc. The below figure shows P/E for 4 companies in the Automotive sector. If we take the case of Toyota Motor Corp the P/E stands at 13.2 which is more than the Average P/E of 11.575. This means that Toyota is currently priced higher than average and hence could potentially be not a good stock to buy currently based on relative analysis. While General Motors seem like a good investment since it is way less standing at 6.6. This analysis cannot be a solve criteria to make a decision but one of the many discussed above.
**More than 3 methods are used by analysts and an average or weighted average price of the 3 target prices are used to root out any anomalies that are inherent in most of the methods because estimates are dependent on assumption and forecast. **