How Stocks are Valued
What is Valuation?
Valuation is the process of determining or assessing the worth
of a given stock or asset.
How are stock valued?
* Fundamental Valuation
This type of valuation focuses on the financial attributes of the
company and its stocks. Factors which are carefully analyzed
during the fundamental type of valuation include financial history,
profitability trends, capital efficiency, and financial structure.
Fundamental valuation uses a number of distinct methods for valuing a stock including
the Cash Flow Valuation, the Divident Discount Model, Asset based Valuation and
Transaction based Valuation.
* Cash Flow Valuation Model
The cash flow model is the present value of all future cash flows discounted at an
appropriate rate that compensates for the risk of the investment. The cash flow used is
generally the free cash flow which is a function of net income, amortization/depreciation
changes in working capital and capital expenditures. The model breaks down for companies
with negative free cash flows.
* Dividend Discount Model (DDM)
The dividend discount model values a stock based on the discounted present value of current
and future dividends. The inputs to the model are the future dividends, discount rate
and growth rate of dividends. It is considered a conservative
valuation approach, but the model is difficult to apply because it is difficult to find the correct
discount rate and the growth rate of dividends. There is no agreement within the finance community
on what the correct discount rate should be for any given company. The grwoth rate of dividends
is hard to forecast even for stable companies with years of dividend growth.
Both of these inputs are in the divisor of the DDM forula which can lead to large errors in the
valuation estimate.
Asset Based Valuation
The asset based valuation values a company based on the sum of the values of the underlying assets.
Cash is valued at cash, publicly traded stock is valued at the market price and
estimates are derived for the values of privately operated subsidiaries. Tese are then added
together to produce an estimate of the company value. This method is especially well suited for
valuing conglomerates and investment holding companies.
Transaction Based Valuation
This approach values a company based on the sales prices of comparable companies in the
same industry sector and approximately the same size. Prices in this market are established by
private equity firms, corporate acquirers and independent deal makers. Key parameters that
are considered in this framework are EBITDA / EV, interest coverage and stbility of free cash flows.
What are the Things to Consider when Valuing a Stock?
* Financial Characteristic
The financial characteristic of a stock may be measured by carefully
studying its company’s revenue, cash flow, profitability trend,
contracts, intangible liabilities, non-cash expenses, tangible assets,
earnings, capital expenditures and contingent liabilities. A stock
from a company with excellent financial characteristics has a high
possibility of getting a high value.
* Marketing Attributes
The marketing attributes of a given stock may be evaluated by looking
at the company’s physical location, competition trends, profit
potentiality, distributor – supplier relationships, product
demands, and rendered services. A company with competitive marketing
attributes has higher valued stocks because investors are convinced
that it will perform better in the future.
* Business Condition
The overall condition of the company and its assets has to be considered
too when it comes to valuating stocks. Factors such as the state
of bookkeeping, the maintenance of facilities, the efficiency of
equipment, and the condition of work environment are really important
because they are involved in the determination of whether the company
has the potential to gain more profit in the future or not. A particular
stock from a company with a great business reputation will have
a higher value as compared to those stocks from lesser known institutions.
* Economic Aspects
Economic factors such as labor relations, stock market performance,
economic stability, consumer confidence, interest rates, and regulatory
environment are also considered when it comes to valuating a particular
stock. A particular stock from a company that is currently operating
its business in an economically-challenged state or country is more
likely to get a lower value.
* Security Features
The stock market
is one of the largest financial industries in the world so it is
expected that it is vulnerable to risks and fraud. The value of
a company stock is also dependent on the security features of the
company because investors usually purchase those stocks in which
they are assured of the security and the protection of their money.
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