Valuation of stocks

First, in order to value stocks, we must understand what intrinsic (or fundamental) value is. It is an important concept and is defined as the amount a rational investor would pay for an asset given they understand and have knowledge of the asset. It is a manner of describing the true value of an asset and will not always be identical to the current market price, because the current market can be under or overvalued. [1]

To appropriately value stocks, we also need to understand the concept of efficient market theory. This very common hypothesis will form the basis of any stock valuation that we do.

Efficient market theory (EMT)

Efficient market theory (EMT) states that at any given time a market operates efficiently because all publicly known information factor into the price of an asset. So, if Company A is worth $2 per share, and has one million shares, it would mean they are worth $2 million; if the share price fell, people would buy these shares and hold them in order to profit as soon as they return to their equilibrium price of $2 per share. This means that under EMT, investors cannot get ahead of the ‘game’ because everyone has the same information. We must note that EMT simply argues that over time, assets will be valued optimally, not that they are right at any specific moment.

Here is an example of EMT in graph form:

Click to enlarge

Source: Financial Management Pro [2]

Forms of EMT

There are three forms of EMT: [3]

• Strong: At any given time in the market, the market reflects all information, public and private, over time so no investor can gain a considerable advantage.
• Semi-strong: At any given time, the market reflects all publicly available data, including historic trading information and business fundamentals. However, traders can get ahead with non-public data.
• Weak: The market reflects all historic data for asset prices. Fundamental analysis under this theory can help in assisting future profits.

Read the following articles to understand some arguments around the EMT.

Read: (Optional)Efficient market hypothesis: Is the stock market efficient? [4]

Read: (Optional)The efficient market hypothesis and its critics (digest summary) [5]

There are many methods to value stocks, and some of them are highly complicated. For our purposes, we will focus on a few popular methods.

Stock valuation can be split into two categories. Let us learn more about them.

Intrinsic valuation

This is a calculated measure of valuation that will be based on publicly available information about the company, typical from its annual report. Various methods can be used here, and analysts will use different methods depending on their preference and the companies they are valuing. Each method might deliver a slightly different valuation. It is reasonable to expect that an intrinsic valuation will differ from the share price.

Methods of intrinsic valuation:

Dividend discount model (DDM)

This model considers the future earnings (dividends) that shareholders might receive and discounts them to determine what their value might be today (remembering that this is called the present value). The formula is as follows:

[PV = frac {D} {r − g}]

Where: D = dividend one year from now, r = discount rate, and g = constant growth of dividends.

The following assumptions apply in the model:

a. Dividend growth is constant.

b. Dividends are the appropriate measure of shareholder wealth.

c. r > g, otherwise mathematically it is impossible.

You should notice a few things with this model:

• The difference between r and g is vitally important, and as the difference widens, the stock falls; as it narrows, the stock rises.
• Assumptions in r and g are important, as small changes can cause large valuation differences.

We can estimate g using the following formula:

[g = left( 1 − text{dividend payout ratio}right) times text{ROE}]

Discounted cash flow method (DCF)

This is the method that we have previously discussed in Week 3, and it is based on the premise that we will purchase the company for its future free cash flows. The only step we will need to add is to divide our NPV, cash, and cash equivalents (our intrinsic value) and divide them with the number of shares outstanding.

Relative analysis

The other method of valuation that we can use is called relative analysis. Here we will typically calculate key financial ratios and compare them with those of similar companies in order to determine a stock price valuation. The most challenging part of this analysis is ascertaining whether or not the companies we have chosen for our comparison are the right ones.

The following methods are commonly used:

Price-to-earnings (P/E) ratio

PE Ratio = (frac{text{Market Value per Share}}{text{Earnings per Share}})

Price-to-book (P/B) ratio

PB Ratio = (frac{text{Market Value per Share}}{text{Book Value per share}})

where:

Book Value per Share = Total Common Shareholders Equity – (frac{Preferred Stock}{Number of Outstanding Common Shares})

Enterprise Value-to-EBITDA ratio

EV/EBITDA ratio = (frac{text{Enterprise value}}{text{EBITDA value}})

[= frac{left(text{Market Capitalisation}right) + text{Value of Debt} + text{Minority Interest} + text{Preferred Shares} − text{Cash & Cash equivalents}}{text{Operating Profit} + text{Depreciation} + text{Amortization}}]

In the following video, Warren Buffet shares thoughts on the most important aspects of evaluating a company.

Watch: Warren Buffett explains how to calculate the intrinsic value of a stock (8:03) [6]

Give it a go

You now know to perform some of these calculations to understand the valuation of your stocks and bonds. Do you have any questions regarding the same? Do you think you have an alternative method to calculate these values?

Let your fellow learners know in the comments section.

References

_{1. Intrinsic value definition [Internet]. IG. Available from: https://www.ig.com/en/glossary-trading-terms/intrinsic-value-definition}

_{2. Smirnov, Y. Efficient Market Hypothesis (EMH) [Internet]. Financial Management Pro. Available from: http://financialmanagementpro.com/efficient-market-hypothesis/}

_{3. Reed, E. A guide to efficient market theory [Internet]. Smartasset; 2020 Jan 2. Available from: https://smartasset.com/financial-advisor/efficient-market-theory}

_{4. Efficient market hypothesis: Is the stock market efficient? [Internet]. Forbes; 2011 Jan 12. Available from: https://www.forbes.com/sites/investopedia/2011/01/12/efficient-market-hypothesis-is-the-stock-market-efficient/#74cdc9ad76a6}

_{5. Malkiel, BG. The efficient market hypothesis and its critics (digest summary) [Internet]. CFA Institute; 2003 Nov. Available from: https://www.cfainstitute.org/en/research/cfa-digest/2003/11/the-efficient-market-hypothesis-and-its-critics-digest-summary}

_{6. Warren Buffett explains how to calculate the intrinsic value of a stock [Video]. Cooper Academy – Investing; 2019 Sep 5. Available from: https://www.youtube.com/watch?v=TmWW7tsCuGQ&ab_channel=CooperAcademy-Investing}