Stock valuation is the process of determining the intrinsic value of a business. This involves analysing the financial statements and understanding the business model, assets, liabilities, revenue, and other key quantitative and qualitative metrics. By doing so, we can assess whether an asset represents a viable investment opportunity or not. The underlying factor of stock valuation is that the true worth of a company may be different than its current trading price.

TABLE OF CONTENTS:

Stock Valuation explained for beginners.

Many stock investors do not fully appreciate or comprehend the actual value of the companies they invest in. Some companies are considerably undervalued in comparison to the underlying assets that support the business. On the other hand, some companies are excessively overvalued, without any earnings, and are merely driven by hype and a story. Knowing the difference can help investors make money while also avoiding losses.

Valuing a business serves two purposes: determining its fair value and establishing a target price. The target price is the result of the valuation process and represents the price you believe the stock should or could eventually trade at.

Valuing a business is both an art and a science. It involves assessing the financial health of the company, potential for growth, competitive landscape, and the industry and market opportunity to determine the value of the business. Stock valuation is akin to determining the fair price of a product or service.

The stock market is filled with individuals who know the price of everything, but the value of nothing.

Philip Fisher

There are many methods of valuation that we will discuss in the valuation component of the website. However, for now, I want to expand on alternative ideas around stock valuation to provide a comprehensive view of the topic. While valuing a business is the foundation of investing, I have moved away from complex modelling and taken a more “art” side of valuation over the years.

The reason why valuation requires both art and science is that it is based on predicting the future prices of a company and trying to gain from this estimation. It is all about IF my valuation is correct, I could profit.

Comparing Valuation to day-to-day money decisions.

When making purchasing decisions, it’s common to shop around for the best deal. For example, when buying home appliances, you compare various brands, read reviews, and look for the best value for your money.

Similarly, when purchasing a property, you conduct market research and compare prices to ensure you’re not overpaying. Or if you are paying beyond the asking price, you see a future opportunity that others overlook. If you’re borrowing money from the bank, they will value the asset to determine the loan amount and make sure they don’t lend more than the property is worth.

However, when it comes to stock valuation, investors often don’t approach the market with the same mindset. They often invest without fully understanding the underlying business and whether it presents a compelling buying opportunity. In all walks of life, value is important, and it’s essential to consider it when spending money, including when investing in the stock market.

Approaching the stock market with this valuation mindset can be very helpful. It creates a contrarian approach by being able to step back and think about value constructively. In the same approach to how you would shop ask the same questions. Is this a good buying opportunity? Am I overpaying? Is this a bargain? Is there an alternative option? It pushes you to develop an independent outlook on investable ideas.

Investments should never be rushed without understanding their value. Just as you wouldn’t hand over a cheque to purchase a car without doing your research and ensuring you’re getting your money’s worth (I hope).

Value is in the eye of the beholder.

Valuation and target price are subjective matters and can vary greatly depending on personal opinion. Just like how some people prefer expensive items while others prefer cheaper ones, the same applies to investment decisions. The value of an asset is in the eye of the beholder, and it’s important to develop knowledge, conviction, and confidence to back up your investment decisions.

Think about a $2,000 laptop. If you rarely used a laptop and it was not important to your activities or work, then it may seem expensive. However, to someone who uses it, loves technology and enables them to work more efficiently, then it may be a bargain.

One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.

William Feather

It doesn’t matter whether you are looking for undervalued opportunities or investing in high-growth ideas that are perceived as overvalued. The perception of what is expensive or cheap can differ from one investor to another. Analysts have widely different target prices because they use different valuation methods, and have different needs, expected returns, and risk appetites.

For instance, a different discount rate in a DCF calculation can seriously impact the final target price. Even using a different WACC calculation and terminal value with a 1% variance can lead to significant price discrepancies in the enterprise value. Therefore, it’s important to understand the different valuation methods and not solely rely on numbers to make investment decisions.

It is important to keep an open mind. Understand how others come up with their target prices. Don’t become arrogant that your valuation is the ONLY right price. There are so many moving parts and inputs when it comes to valuing a business.

Stock valuation is not the end all.

Investors sometimes rely too much on numbers and valuation techniques, outsourcing their thinking to spreadsheets. While these tools can be helpful, it’s important to avoid “Analysis Paralysis,” where the focus on achieving an exact target price prevents the investor from making sound investment decisions.

Valuing stocks is simpler when there is a lot of historical data and coverage on a company’s earnings. But when valuing an emerging high-growth small-cap, things can get more complicated. It’s essential to consider not only the numbers but also the potential size and likelihood of growth. This is where extrapolating growth projections and target market analysis is a good practice to create a bigger picture but not a reliable technique.

Investors should not get tied to numbers and allow the price they come up with using valuation models to dictate their decisions. A high price doesn’t necessarily mean a bad investment if the growth prospects are good. Conversely, a low price doesn’t always constitute a bargain. The investor must assess whether the company can recover or continue to sink.

Valuation is not an exact science, and no one has a crystal ball. Therefore, investors need to think innovatively, ask the right questions, and look beyond the numbers and various methods. They should not substitute a deeper level of thinking just because they’re focused mainly on valuation techniques.

That is why Valuation is only one part of a sound Investment Process, in addition to using a Checklist and also conducting an in-depth Investment Thesis.

The issues with stock valuation.

Valuing a stock is an assumption, and sometimes investors believe that it needs to be 100% accurate. However, it is not possible to create a precise calculation on something that is unknown in the future. We are forecasting earnings and growth, and these projections cannot be assumed to be correct. Businesses do not grow linearly. We are extrapolating current real-time data into a 5- or 10-year uncertain future based on a host of moving inputs.

The more complex a model or valuation technique is, the less accurate it may be. This is because you have such tight growth calculations or estimated assumptions that can throw the forecasting into another stratosphere.

Given that the future is inherently uncertain, we do not believe the value of any business can be known with certainty at a given point in time, so our aim is to be generally right as opposed to precisely wrong.

Wally Weitz

You are trying to determine not only a growth rate but also the right terminal value, the right discount rate, and the right maturity rate years in advance. To think that you can get this 100% right is not logical.

It also comes back to the numbers that will govern the output. If an analyst has a discount rate in line with the US bond rate, let’s say 4.5%, but I demand a 10% annual return and use this as my discount rate, that is a 5.5% variance in the numbers.

If I think a company can grow its free cash flow at 7.5% a year and then 3% into perpetuity, and another investor thinks this is wild and uses a more conservative approach, what do you think the output would be?

What is the best valuation method to use?

It is crucial to use a valuation model that is suitable for the purpose and context of the valuation. By understanding all the available methods, you can assign the right method to the right business.

Different businesses have different business models, and no single valuation technique can be used for all businesses. Some companies are at different stages in their life cycle, and certain industries favour different techniques. For instance, you wouldn’t use the same valuation model for a large-cap dividend-paying business as you would for an emerging hyper-growth business that is not yet profitable.

The key questions before I attempt to value a business are:

How does this business make money?
What stage of the business cycle is the business?
What is the best way to model the income statement?

Each valuation method has its advantages and disadvantages. By comprehending all the techniques and their variations, you can align with the method best suited to your investment process and the business you are trying to value.

You don’t have to use just one model. It’s a good practice to use a combination of valuation techniques to create a range of possible scenarios. I typically use three models, including the Reverse Discounted Cash Flow model, a quick multiples valuation (comparable companies’ analysis) and a formula for estimating my “Required Returns”. This provides a good understanding of the business without having to rebuild the entire revenue model or perform other complex forecasting.

It’s important not to rely too heavily on one style over another. By using a few valuation techniques in combination, you can create a more comprehensive picture of the business.

Absolute Valuation Vs Relative Valuation.

There are generally two methods for stock valuation: Absolute valuation and Relative valuation.

Absolute valuation involves determining the intrinsic or true value of a stock by analysing the fundamental information of the company. This primarily focuses on the company’s financials, earnings, financial statements, and dividends and excludes competitor comparisons. Absolute valuation attempts to reconstruct the income statements and considers the growth to estimate the future value of the stock. The valuation techniques typically used include the dividend discount model, discounted cash flow model, and reverse DCF model.

Relative valuation, on the other hand, uses investment ratios and multiples to determine the value of a business through a comparative approach. By comparing these multiples to other companies and the industry, we can get a sense of where the business is priced. If a company is priced higher based on a multiple like a P/E, we assume it is overvalued. By understanding where a business is valued against its peers and also against its own historical average, we can determine what is or isn’t priced in by the market. We can also compare an idea to a target company that it could potentially become or compete with.

Both approaches can be used simultaneously. For example, you may choose to use a DCF model and then compare the multiples of the business to another one to get a clearer picture of the value of the business.

In Summary…

It’s understandable at this stage if you feel intimidated by the idea of using valuation techniques to determine the value of a business. However, let’s continue exploring this topic as it is an important aspect of investing. I want to highlight that there is no “one-size-fits-all” valuation model that guarantees accuracy. If it were that simple, everyone would be successful investors.

Personally, I have invested in companies without using any specific valuation model. Instead, I conducted thorough research on the company’s financial statements, market potential, competitive advantages, and growth prospects. I had a good understanding of how the company was priced in comparison to its peers, and I believed it had the potential to continue growing. This approach worked out well for me, as the investment proved to be profitable.

However, it’s still crucial for investors to have an understanding of common stock valuation techniques and when to apply them. By knowing the true value of a stock, you can make informed decisions about whether to buy, hold or sell. It’s important to have the confidence to not overpay for stocks while also not underestimating potential investment opportunities.

One of the great indirect advantages of utilising stock valuation methods is that it provides investors with an in-depth understanding of the business model, how a company generates revenue, and where the real opportunities lie. This process involves analysing financial data, researching the markets and industry, and creatively considering how an idea can evolve and expand. All of this helps to build a strong conviction in one’s ideas by gaining a deeper understanding of a business.