In this article we’re going to explore how to value stocks, without relying on the formula for stock valuation. We’re just going to focus on the underlying intuition and rationale behind how stock valuation works.
Stock valuation can be as simple or as complicated as we like. It doesn’t matter whether you’re looking at a “growth stock” or a “value stock”; a “meme stock” or a “sin stock”.
And it doesn’t matter whether you’re looking to conduct growth investing or value investing.
Yes, stock valuation can become quite complex; however, the fundamentals largely remain the same.
So let’s start there – the fundamentals. Let’s start with something you’ll likely find intriguing.
There’s No Such Thing as a “Correct” / “True” Value.
Despite what anyone might tell you, the fact is there really is no such thing as a “true” or “perfectly correct” value.
The best we can do is get to a ‘reasonable estimate’ for the intrinsic value / fair value of a stock. More on that in a bit.
That’s ultimately because valuation (note, not just stock valuation) is:
- Context dependent, and
- Preference dependent.
Subjective, Contextual and Preference Dependance
Imagine you own a business which generates a substantial amount of earnings each year.
The company’s earnings figure can be whatever you fancy, but it’s a good idea to think of some earnings figure.
How much would you be willing to sell this amazing business for?
It’s a good idea to pause for a bit and just think about how much you’d be willing to sell your business for. And if you do actually own a business, it’s worth thinking about how much you want to sell it for.
Got a figure? Great.
Now consider this.
Imagine that the business still exists.
And the company’s earnings figure is identical to the figure you thought of above.
But it’s not you who owns it.
And you don’t want to sell the business; you want to buy it.
How much would you be willing to pay for this amazing business?
Chances are, the amount you’re willing to buy it for is considerably – if not substantially – lower than what you’re willing to sell it for.
And that’s precisely the point!
Valuation is subjective! It’s context, and preference dependent.
Generally speaking, sellers will tend to value their assets higher than buyers of the same assets.
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How Do We Decide What’s a Fair Value?
Ultimately, in the context of stock valuation, the “reasonability” of an estimate (i.e., whether it’s a fair value) is based on:
- The need, and
- The believability of the ‘story’.
What Do We Mean by “Need”?
“Need” here refers to the sort of context – the rationale / reason – for conducting the stock valuation exercise to begin with.
If for whatever reason, you desperately need to sell your business, then you’ll likely get a raw deal.
If on the other hand, you have plenty of time, and have several prospective buyers for your business, then you’ll likely get a much better deal.
That’s as far as the “need” side of the story goes. But what determines the believability?
Believability of the Story
We use numbers, math, and logic to determine the ‘believability’.
While stock valuation is subjective, fortunately, we have some techniques that help us bring in objective metrics and combine them with useful subjective proxies.
The specific numbers and formula for stock valuation we use vary depending on the model you’re working with.
Interpreting the ‘Story’
If the current market price of the asset is greater than what the ‘story’ suggests, we think of the asset as ‘overvalued’.
If on the other hand, the current price is lower than what the story suggests, then we’re looking at an ‘undervalued stock‘.
Lastly of course, if the current market price of the asset is equal to what the story suggests, then we say the asset is fairly priced.
We define the value based on the ‘story’ as the “intrinsic price” or “intrinsic value”.
The intrinsic value is the price / value at which the asset should be trading at, based on its firm fundamentals.
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How Do We Get To The “Intrinsic Value”?
Broadly speaking, while there might well be hundreds if not thousands of different “valuation models” to get to the intrinsic value, all stock valuation models can be grouped into:
- Discounted Cash flow (DCF) valuation technique
- Relative valuation techniques (aka Multiples valuation technique, Comparables valuation, “Comps” valuation), and
- Contingency based techniques (e.g. with Options).
Regardless of which model / approach you use, you’ll ultimately have your version of the ‘story’. You’ll then compare your ‘story’ with that of the market and make some conclusions.
Stock Valuation Using Discounted Cash flow (DCF)
Discounted cash flows are simply future cashflows discounted back (or ‘brought back’) to the present day (i.e., to their “Present Value”).
In other words, it’s a case of seeing how much money in the future is worth to us today, right here, right now.
This valuation technique largely relies on 2 things:
- Expected future cash flows, and
The risk is incorporated into what’s called the “discount rate” (aka Cost of Capital, Opportunity Cost of Capital, Hurdle Rate, Required Rate).
This discount rate incorporates two key risks including:
The expected future cash flows are estimated in a battery of different ways.
However, regardless of how it’s estimated, it will likely end up being one of the following:
- Free cash flow (FCF)
- Free cash flow to Equity (FCFE, FTE)
- Dividend (assuming we’re dealing with dividend-paying stocks)
Regardless of which free cash flow it is (or if you’re using dividend), it will ultimately be estimated by starting off with some sort of historical earnings (say, Net Income)…
And then forecasting future earnings growth in some manner before trickling down to an estimate for the expected future cash flow.
Estimating the earnings growth or cash flow growth will naturally require estimating a growth rate, too. But now we’re digressing.
The key takeaway is that the value of a stock – its fair value – is equal to the “Present Value” of its future cash flow.
RELATED: How to Calculate Present Value
Stock Valuation Using Multiples
An alternative approach is to work with “Multiples”. This approach is also called “Relative Valuation” or “Comparables Valuation”, or just “Comps Valuation”.
The idea’s to value shares based on what its comparable firms are worth.
In other words, the idea’s to get to the relative value of a stock (relative to its comparables).
Intuitively, if your neighbour’s house is worth $482,529 then it’s likely that your house will be worth somewhere in that ballpark. It’s unlikely that your house will be worth $100,000 for instance. Or even $2,000,000 for that matter.
Multiples for valuation is probably one of the easiest techniques of them all. The trick of course, and the challenge, is in knowing how to find the right comparable firm.
Just like real estate, stocks too have ‘neighbours’. It’s just that they’re not physically located next to each other.
So we rely on and use robust “matching” techniques to find the right comparable firm.
And the valuation estimate you come up with really does depend on how good the comparable firm is.
In other words, it’s less about which Multiple you use to obtain the share price – e.g., PE ratio (aka Price-Earnings Ratio) or Market to Book – and more about which firm you’re comparing the target firm with.
Contingency Based Stock Valuation
Last, but certainly not the least, we can value stocks using Options. This approach is essentially about “reverse engineering” the price.
That’s because the value of an option is based on the value of a stock. And that is because options are “derivatives” in that they derive their value from an underlying security – in this case, stocks.
So if you know the value of an option, you can “reverse engineer” it to obtain the value of a stock. Be that at the stock level, or the firm level (e.g. by calculating the enterprise value and then working out the stock price).
Justifying the Purpose of Stock Valuation
Notwithstanding the importance of any of the concepts we’ve covered above, it’s important to consider whether or not carrying out a valuation exercise is justified.
And this really depends on whether you believe in “efficient markets / Efficient Market Hypothesis” or not.
If markets are “efficient”, it means that the prices of all securities reflect all the available information out there.
In other words, if financial markets are efficient, then market cap (aka market capitalization) of all firms would be equal to their respective fair value.
RELATED: What is Market Capitalization
And if it’s the “correct” price, then there’s no point in carrying out a valuation (because you can just see the current stock price online!).
Equally, there would be no point in conducting fundamental analysis for example.
By attempting to value any stock, by picking up a calculator, or opening an Excel® spreadsheet, you implicitly imply that you do not believe markets are efficient.
And that is okay, despite what the folks in Asset Pricing will tell you!
Related Course: Stock Valuation (using Multiples)
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