Stock valuation is an important tool that can help you make informed decisions about trading. It is a technique that determines the value of a company's stock by using standard formulas. It values the fair market value of a financial instrument at a particular time. The reason for stock valuation is to predict the future price or potential market prices for the investors to time their sales or purchase of investments.
The stock valuation fundamentals aim to value the “Intrinsic” value of the stock that shows the profitability of the business and its future market value.
Stock valuation is usually divided into two groups:
Absolute valuation intends to find the “intrinsic” value of the financial instrument. This method only focuses on the fundamental strengths of the company as the dividends, cash flow, and the growth rate for a single company.
The methods used under Absolute Valuation are:
Dividend Discount Model (DDM):
This is one of the basic calculations of the Absolute Valuation model. It calculates the true value of the company by assessing its dividend payout to its shareholders. According to this method, the dividend is the representation of the actual cash flow of the company. It shows the true value of the company’s share.
Discounted Cash Flow model (DCF):
This method is suitable for companies that do not make regular dividend payments to its shareholders. The method uses the discounted future cash flow of the company to calculate its market value. The method is applicable for companies that pay a dividend or do not pay a dividend to their shareholders.
The Comparable method does not use any kind of parameters to find the market value. Instead, it compares the stock price multiples to a set benchmark value. The rationale for this method is that the similar financial instruments carry the same market value.
Methods used under Relative Valuation:
Relative Valuation method uses ratio and other types of valuation methods to ascertain the value of the stock. The ratio is the most commonly used method as it is easy to calculate and is available at hand. The common ratios used are:
Price per earning
Earnings per share
Sum of Perpetuities method
Return on assets
Enterprise value-to-sales ratio
These ratios help the traders and the investors to calculate the fair value of stock and make informed decisions when transacting in the stock market.
If you intend to invest in the stock market, you can make use of ratios and methods to evaluate the value of a stock. However, valuation methods are not the only tool to conduct trade, and you should consider other parameters such as history of the company and its trend before trading. It is also prudent to conduct valuations of different ratios and find the average of them to obtain a clear market value of the stock.