The ABC of Stock Valuation for Beginners

Jaya Sharma
Senio r Executive Co ntent

Updated on Feb 8, 2024 14:58 IST

Stock valuation is a method that determines the intrinsic or theoretical value of a stock in future.
It is important as it helps investors in identifying how a stock will perform in future. This helps
them make the decision of whether they want to invest in a stock or not for gaining profit. Since
the intrinsic value may differ from the current price of the stock, stock valuation becomes
necessary.

T able of Contents

Introduction to Stock Valuation

T he Importance of Stock Valuation in T rading

Stock Valuation Strategies f or Beginners

How is the Stock Valued?

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 Methods of Stock Valuation
Price-to-Earnings (P/E) Ratio

Dividend Discount Model

Discounted Cash Flow Model

How to Choose the Appropriate Stock Valuation Method?

Absolute Valuation Models

Relative Valuation

Factors Inf luencing Stock Valuation

Common Mistakes to Avoid in Stock Valuation

Pros and Cons of Dif f erent Stock Valuation Methods

Introduction to Stock Valuation

Def init ion of St ock Valuat ion

Stock valuation is a process of company valuation and comparing its valuation to the current
market price. T his is done to determine if a stock is under or overvalued. T his is a theoretical
method of calculating the value of companies and their stocks. It is based on the
f undamental aim to provide an estimate of the stock's intrinsic value. T his is based on f uture
cash f low prediction and the prof itability of a business. Stock valuation should not be
conf used with business valuation.

How t o Pick St ocks: Beginners Guide f or New Invest ors

There are a number o f metho ds o f investment. These include mutual funds, SIP,
fixed depo sits, etc. Sto ck o r equity is a type o f security that represents a
percentage o f yo ur share...re ad m o re

The Import ance of St ock Valuat ion in Trading

Stock valuation is important f or the f ollowing reasons:

Stock valuation helps in predicting f uture market prices and the potential prof it f rom the

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 expected price movement. T hrough this, the stocks that are undervalued, are bought.
T he stocks that are overvalued, are sold. We will learn about the reason f or selling
overvalued and buying undervalued stocks in the next section.

Stock valuation helps in determining if a stock is undervalued or overvalued relative to

its potential. T his is especially benef icial f or investors. T hrough valuation, investors can
compare the stocks within an industry. Investors can even identif y the f uture prospects
of the company. T his can be extremely helpf ul. For investors, this is helpf ul since they
can estimate the returns that investors will get f rom buying the stock at the current
price.

Stock Valuation Strategies f or Beginners

For beginners, it is very important to not get too impulsive while valuing stocks. T hey should
start their journey of valuing stocks by f irst understanding the f undamentals. Further, here is
a step-by-step journey f or beginners.

Understand the Importance: It is very important to understand why stocks are valued.
Along with that, they should be theoritically aware of stock valuation.

Understand the company: You need to understand the f inancial characteristics of the
company such as the dividend payment patterns or the cash f low predictability.

Identif ying right valuation method: Once you have understood the company, it is crucial
to identif y the stock valuation method that f its the company. Does the company pay
dividend or not? Does it have f ree cash f low or not? All these questions help in
selecting the right stock valuation method.

Industry Norms: It is important to consider industry norms while choosing a valuation

method f or stocks. T his is helpf ul since dif f erent industries work dif f erently.

How is the Stock Valued?

T here are multiple ways to value a stock. First, we need to ask questions. T hese questions
will help us understand the f inancial position of the company. Let us take a look at some of
the important questions:

How is the company making money?

Are the products and services of the company in demand and what is the reason?

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 What is the company's perf ormance history?

Is the company positioned f or prof itability and growth?

What is the amount of debt on the company?

What is the current situation of the company's industry?

What are the challenges that are being f aced by the company?

Are there any political, economic, religious or cultural risks that the company might
f ace?

While these are important questions to be asked bef ore planning stock valuation, let us now
learn about the dif f erent methods of stock valuation.

Methods of Stock Valuation

T he f ollowing methods are used f or stock valuation:

1. Price-t o-Earnings (P/E) Rat io

Any company that grows f aster than its competitors has a high P/E ratio. T his ratio is
calculated by dividing the market value price per share by the company's earnings per share.
It is used f or determining the market value of stock and f uture earnings growth. A higher P/E
ratio shows that investors want to pay higher share prices at present due to the growth
expectations in f uture. It also means that the stock's price is high compared to earnings and
is possibly overvalued. A low P/E ratio indicates that the current stock price is low as
compared to the earnings.

T he market price of the share of a company is Rs 1000. In this case, the earnings per share
is Rs. 10 which means that the P/E ratio will be 10. T his means that investors have to pay
rupees 10 f or every rupee of the company's earnings.

2. Dividend Discount Model

T he dividend discount model or DDM is a quantitative method f or predicting a company's

stock price. It is based on the theory that the present-day price is worth the sum of f uture
dividend payments when they are discounted back to the present value. T he aim is to

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calculate the f air value of stock regardless of the market conditions.

If the value obtained f rom DDM is higher than the current trading price of shares, the stock
is undervalued and should be bought. In case the value obtained f rom DDM is lower than the
current trading price of shares, the stock is overvalued and should be sold.

Here:

Intrinsic Value Per Share = D1 ÷ (ke – g)

D1 denotes the expected dividend f or the next year

ke represents the cost of equity

g represents the dividend growth rate

Dividend Payout Rat io: Calculat ion and Impact

Dividend Payo ut Ratio represent the amo unt o f earnings after tax (EAT) o f a
co mpany that is paid to its shareho lders. To calculate the payo ut ratio , it is
calculated by dividing...re ad m o re

Dividend Yield vs Dividend Rat e: Underst anding t he…

Dif f erence
While dividend yield refers to the percentage o f the current sto ck price o f a
co mpany paid o ut as dividend o ver a year, dividend rate is the amo unt o f mo ney that...re ad m o re

Dividend Yield: Calculat ion, Advant ages and…

Disadvant ages
Dividend yield assesses the quantum o f earning by to tal dividends that
investo rs make thro ugh investment in a co mpany. This yield is expressed in percentage where it is
calculating by dividing...re ad m o re

3. Discount ed Cash Flow Model

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Discounted cash f low is a method used in the valuation of stocks. It is used f or estimating
the value of investments based on the expected cash f low in f uture. It determines the value
of the investment today based on the projections of money that the investment will generate
in f uture. T his stock valuation method helps in determining whether an investor should buy
the stocks of the company.

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Let us say that the current stock price is $50. T he expected f uture cash f low per share f or
the three f ollowing years will be as mentioned below:

Year 1: $5

Year 2: $7

Year 3: $10

T he discount rate is 10%.

Let us now calculate the present value f or each cash f low. Here, Present Value (PV) = Future
Cash Flow / (1 + Discount Rate)^Year.

As per this f ormula, the present value will be:

Year 1 PV = $4.55

Year 2 PV = $5.92

Year 3 PV = $7.51

T he sum of all f uture cash f lows will be:

T otal Present Value (T PV) = $4.55 + $5.92 + $7.51 = $17.98

According to the f ormula:

T PV > Current Price, the stock is undervalued

T PV < Current Price, the stock is overvalued

T PV = Current Price, the stock is f airly valued

Let us now compare the current value with the total present value. As it is evident, the total

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present value is less than the current price. T his indicates that the stock is overvalued based
on the f uture cash f lows and the chosen discount rate.

Learn to build DCF model

How to Choose the Appropriate Stock Valuation Method?

Since every stock is dif f erent, f inding the most appropriate method is not so easy. Every
stock valuation method has its own advantages and disadvantages. Some industries with
unique characteristics will require multiple valuation methods.

Multiple approaches will be adopted to make comparative evaluations of the company's value
in the market against competitors. While choosing a valuation method, ensure that it is
appropriate f or the f irm that you are analysing. T here are, however, two categories of
valuation methods: absolute valuation and relative valuation.

1. Absolut e Valuat ion Models

T hese stock valuation methods try to f ind the intrinsic value of the investment based purely
on the f undamentals. T his means that the f ocus will be strictly on the cash f low, growth rate
a n d dividends. Dividend discount model, residual income model, asset-based model and
discounted cash f low model are the dif f erent types of absolute valuation models.

2. Relat ive Valuat ion

T hese models compare companies. It involves the calculation of ratios and multiples
including price-to-earning ratios with multiples of similar companies. T hese models are
relatively easy and quick to calculate compared to the absolute valuation model. Most
investors and analysts start the analysis using this model.

Financial Rat ios Cheat Sheet : A Complet e Guide t o All…

Rat ios
Financial ratio s are the relative measurement o f two numerical values. These
values are extracted fro m the financial statement o f the co mpany to analyse its financial health. Different
ratio s measure the...re ad m o re

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Factors Inf luencing Stock Valuation

Stock valuation is inf luenced by several f actors including the f ollowing:

Pe rf ormance : One of the important f actors that inf luence stock valuation is how the
company is perf orming. If the company is doing well then the stock valuation will go up
since the stock will be worth more.

Economic and market situation: Another reason that impacts stock valuation is the
situation of economy and stock market. If the economy and the stock market is doing well,
traders will have more conf idence to invest in stocks. T his will lead to an increase in the
stock prices. Hence, it will lead to high stock valuation.

Earnings and profitability: Investors are also inf luenced by the amount of prof it the
company is making and the f uture earnings potential. Higher prof its will make the stock
more valuable.

Supply and demand: It is an important f actor that inf luences stock valuation. If there is
more demand f or a particular share but the quantity of those shares are not enough, then
the price of the stock will increase.

News: Positive or negative news about a company has a strong inf luence on the price of
the stock. If the news f avours the company, then the stock price will go up. If the news is
bad f or the company, then the stock price will go down.

Investor sentiment: One of the f actors that impact the valuation of a stock is investor
sentiment. If the traders are optimistic about buying stocks of a company, it will push the
price up. In case, people are not f eeling positive about a stock, the price of the stock will
go down.

Industry trends: If an industry is growing, its valuation will be generally higher along with
the P/E ratio. T his happens because investors see the potential f or higher f uture growth.
In case, the industry sees declining demand, then the valuation of stocks will go down
since investors do not see f uture growth. T here is a high chance of stock devaluation in
case of industries outranked by the new industries. New regulations within the industry
also impact stock valuation.

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Common Mistakes to Avoid in Stock Valuation

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T he f ollowing mistakes must be avoided in stock valuation:

Using a single valuation method: Many investors use a single valuation method f or
companies with dif f erent characteristics. To prevent subjectivity while determining the
valuation of a stock, multiple valuation methods can come in handy. T hrough multiple
valuation methods, one can see the value distribution which is closer to the intrinsic
value of the stock.

Do not use the wrong valuation method: First, we need to identif y the characteristics
of the company f or which you want to do the analysis. Once you have identif ied the
characteristics, you will identif y the appropriate valuation method to be used. Let's say
that you have to calculate the intrinsic value of the company using DDM. But this
company does not have any f ree cash f low. Since DDM takes f ree cash f low in
consideration or if it does not pay any dividend, then avoid using this method. In case
the cash f low is negative, you do not use DCF model.

Avoid over-optimistic assumptions: If an investor uses over-optimistic assumptions

to calculate the intrinsic value of stock, it will result in calculations that are high and
biased. In case, the assumption is conservative, the stock will reach its intrinsic value
but the stock will be f ar below the intrinsic value. In case investors assume that the
company will keep on growing, it will disrupt the calculation of intrinsic value.

Emotional investing: T his is a barrier to accurate stock valuation. Due to emotional

reactions, there is a high chance that the investor might make an impulsive decision.
T his may result in panic selling when the stock price goes down during market
f luctuation or in greedy buying when the market goes up.

Pros and Cons of Dif f erent Stock Valuation Methods

Dif f erent stock valuation methods have the f ollowing pros and cons:

1. Price-to-Earnings (P/E) Ratio

Pros:

Simplicity: T his valuation method is easier to calculate and can be easily understood.

Comparability: It helps in comparing dif f erent companies within the same industry.

Indicator of Market sentiment: It ref lects what the market can pay f or the earnings of
a company.

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Cons:

Manipulation of earnings: Companies can manipulate earnings through dif f erent

accounting practices that af f ect the P/E ratio.

Not for companies with negative earnings: T his method of stock valuation is not
suitable f or companies that are not prof itable.

No account of future growth prospects: T his valuation method does not take f uture
growth prospects into account until they are in conjunction with growth rates.

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2. Discounted Cash Flow (DCF) Analysis

Pros:

Consideration of Future: T his method of stock valuation considers both historical

perf ormance and f uture potential.

Flexibility: T his method allows adjustments based on the expected discount rates,
growth rates and f uture cash f low projections.

Future cash flow: DCF method f ocuses on the f uture cash f lows of the company. It is
grounded in company's f undamental f inancial perf ormance.

Cons:

Assumption sensitive: Any change in input assumption will lead to signif icant
variations in valuations.

Difficult Future Cash Flow Prediction: It is dif f icult to predict f uture cash f low f or
companies that do not have predictable cash f low.

T ime-consuming: T his is a time-consuming stock valuation method since it requires

detailed f inancial modelling and assumptions related to f uture perf ormance.

3. Dividend Discount Model

Pros:

Dividend Focused: T his valuation method is suitable f or the valuing companies that
pay dividends on a regular basis.

Simple: It is a simple valuation model that involves straightf orward calculations f or

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 companies with stable dividend policies.

Income-oriented valuation: T his model is more appealing to those investors who

f ocus on dividend income.

Cons:

Not for Companies Without Dividends: T his method is not suitable f or companies
that do not pay dividends.

Ignore Non-Dividend Financial Performance: T his method does not consider the
complete f inancial health of the company except dividends.

Dividend growth rate dependent: T his valuation method is highly dependent on the
estimated dividend growth rates.

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o n 0 9 -Feb-20 24.