A stock market is an exciting place. It can help create a decent corpus and fulfil your personal and financial goals. But the trick to succeeding in this market largely depends on the stocks you pick. The stocks you invest in should be chosen after careful research. You must analyse various parameters before picking a stock and investing your hard-earned money. To achieve this goal, you should be familiar with what stock valuation is and how to choose the best stock valuation methods. Here’s all you need to know.
Stock Valuation – definition and meaning
Stock evaluation is defined as the method that helps determine the intrinsic or theoretical value of a stock trading on the exchange. The significance of valuing stocks develops from the premise that a stock’s intrinsic value is not attached to or revolves around its current market price. By understanding its intrinsic value, you can easily determine whether the stock is overvalued or undervalued at its current price. Now let’s understand the types of stock valuation and how to select the stock valuation method.
Stock valuation is mainly categorised into two types which are
1. Absolute stock valuation
This type of stock valuation trusts a company’s fundamental information in which details such as its financial condition and statements are analysed. Various absolute stock valuation techniques mainly investigate aspects like the company’s cash flows, growth rates, dividends etc.
2. Relative stock valuation
This type of stock valuation is concerned with comparing a potential investment with companies in the same sectors. The relative valuation method involves the calculation of key financial ratios of companies in the same industries as well as the derivation of the same ratios for target companies.
Best ways to value a stock
Essentially, there are three methods of stock valuation that are most popular. They are:
1. The Dividend Discount Model
A technique that is typically used for absolute stock valuation, the dividend discount model or DDM is one of the best ways to value a stock. This model follows the assumption that a company’s dividends characterise its cash flow to the shareholders. This model states that the intrinsic value of the stock price of a company equals the current value of its future dividends. This model, however, applies only to companies that distribute stable and regular dividends.
2. The Discounted Cash Flow Model
The discounted cash flow model or DCF is also used for absolute stock evaluation, under which a stock’s intrinsic value is calculated by discounting a company’s free cash flows to the present value. The DCF is also regarded as one of the best ways to value a stock since it does not entail any assumptions about dividend distribution. As such, this model is best suited for companies with unpredictable dividend distribution.
3. The Comparable Companies Analysis
A specimen of relative stock valuation, the Comparable Companies Analysis or CCA stock valuation method aims to derive the theoretical price of a stock as opposed to determining its intrinsic value through the company’s fundamentals. This method uses the price multiples of several similar companies. Commonly used multiples in this method of stock valuation include price-to-book (P/B), price-to-earnings (P/E), and enterprise value-to-EBITDA (EV/EBITDA). From a technical perspective, the CCA method is one of the simplest, but comparing companies can be quite challenging.
Now that you know how to choose the best stock valuation methods, ensure you never rush into your investments. Analyse the model that best suits your investment goals and invest accordingly. For guidance and advisory services on stock market investments, you can reach out to us at Angel One.