The stock market can be a tough place to make money. With millions of investors trying their luck, it is critical that a knowledgeable investor take the time to study, evaluate and assess the fundamental factors that influence stock prices through various stock valuation methods. The appraisal process is one of the most important frameworks for determining the current cost per unit. However, there are many criteria that must be considered to evaluate stocks such as current market price, purchase price and future earnings. Here is a list of some of the most popular ones.
Inventory Valuation Methods:
When talking about inventory valuation methods, there are two main categories: absolute valuation and relative valuation. The “absolute valuation” model attempts to find the intrinsic or “true” value of an investment based on fundamentals. It focuses on metrics such as dividends, cash flow and growth rate of one company without focusing on others.
The other method, the relative evaluation model, compares one company to another in its peer group. This involves calculating multiples and ratios, such as the price-to-earnings multiple, and comparing them to the multiples of companies in the same sector.
1. Reproduction value of assets
Writes: Balance sheet valuation is absolute
When to use: When you need to determine the cost to a competitor of repeat business.
Describe: This method involves evaluating a company’s current assets and determining the replacement cost of each asset. Replacement cost can be evaluated in several ways. The most common asset-based valuation models are the square foot method, the unit-by-place method, the quantity survey method, and the index method.
To understand the method in detail, click here.
Positives: Very detailed and helps to find the real value of the company’s assets in the market. Especially relevant to merger and acquisition issues.
cons: A company’s valuation cannot be based solely on its visible net worth. It also usually only applies to manufacturing companies and business owners who have a large proportion of fixed assets.
2. Benjamin Graham’s Valorization Formula
Writes: Dividend stock valuation method, relative.
When to use: For cash cow companies with a stable business model.
Describe: Also called the Graham number, as the name suggests, the formula was introduced by Benjamin Graham, the father of “Value Investing”. The Graham number is used to estimate the fundamental value of a stock. formula:
The 22.5 comes from Graham’s reasoning process that any stock with a PE ratio above 15 and a price-to-book ratio of 1.5 is overvalued. 15 * 1.5 gives us the magic number 22.5 for the formula. The calculated value is a “reasonable valuation” according to Graham’s formula.
To understand the method in more detail, click here.
Positives: Useful for identifying undervalued stocks.
cons: Overly simplistic.
3. The Power of Earnings (EPV) by Bruce Greenwald
Writes: Dividend stock valuation method, absolute.
When to use: For cyclical companies, fluctuating cash flows, and newly formed companies where less information such as financial statements is available.
Describe: This method assumes two conditions
- zero growth
- current sustainable earnings
This means that the company will maintain its profit levels each year, but the earnings growth will be zero. The method uses a Boolean approach to calculate the possible intrinsic value approach.
The formula for EPV is – Adjusted Earnings/Cost of Capital. To understand the method with an example, click here.
Positives: It does not require estimates of future growth, actual cost of capital, profit margins, and required investments.
cons: It only looks at past financial statements and the company’s balance sheet.
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4. PE form for stock valuation
Writes: Polyethylene doubling stock evaluation process, relative
When to use: To evaluate any company with fixed profits
Describe: The price-earnings ratio or P/E ratio is the relationship between a company’s share price and earnings per share (EPS). The price-earnings ratio is one of the most popular valuation models. It reflects market expectations as to the price to be paid per unit of profit (current or future).
Earnings are important for evaluating a company’s stock as investors need to evaluate the profitability and future profitability of a business.
the PE is high Companies are growth stocks. It is an indication of positive future performance.
While companies with an extension PE is low It is a valuable stock. This indicates that they are undervalued because their current price is trading lower compared to their fundamentals. However, this is a very general statement, and the price-to-earnings ratio should be taken in the context of company size and industry.
To read more in detail, click here.
Positives: It can be used for any company.
cons: It can only be used when comparing companies in the same sector.
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5. Discounted cash flow assessment
Writes: Cash flow valuation, absolute
When to use: Steady free cash flow, bigger companies, predictable companies.
Describe: The discounted cash flow valuation method is used to estimate the value of an investment based on its future cash flow models. Discounted cash flow analysis calculates the present value of expected future cash flows using the discount rate. The present value estimate is then used to evaluate the potential investment.
Where CF = cash flow for the year, r = discount rate
to understand the details, click here.
Positives: Calculations for the time value of money
cons: Assuming future cash flows is a risky business. Just ask Nokia and Blackberry.
6. Reversal of discounted cash flows
Writes: Cash flow valuation, absolute
When to use: Find out the market forecast built into the share price
Describe: The reverse discounted cash flow eliminates the need to project future cash flows. The inverse DCF model calculates the rate of growth that the market applies to the current share price and that shows whether the implied rate of growth of the market is higher or lower than what the company is capable of achieving. This model uses the stock price as a starting point and helps the investor determine whether or not expectations from the company are reasonable.
To understand the details with an example, click here.
Positives: It removes the shortcomings of the discounted cash flow model to a large extent
cons: It merely indicates whether the assumed growth rate of a stock matches the company’s past growth rate.
7. Dividend Deduction Form
Writes: The absolute cash flow method
When to use: For direct comparison of companies belonging to different industrial sectors. It is usually applied to cash cows only.
A commonly used DDM method is the Gordon growth model (GGM). It assumes stable dividend growth year over year. This model assumes three variables:
D = Estimated value of next year’s earnings
r = firm’s cost of capital
g = Constant growth rate of dividends forever
To understand better with an example, click here.
Positives: Considered the time value of money.
cons: It fails when the company has a high growth rate.
Key takeaways from these different stock valuation methods:
- There are multiple ways to value inventory.
- No single method can be universally applied to stock valuation.
- Understanding the context and reasons behind the evaluation numbers is equally important.