Stock Valuation

Valuations rely heavily on the expected growth rate of a company; the past growth rate of sales and income provide insight into future growth. A no-growth company would be expected to return high dividends under traditional finance theory. Ideally, the portion of the earnings not paid to investors is left for investment to provide for future earnings growth. By the end of this section, you will be able to explain how a stock is valued and describe the limitations of valuing a company with dividends that have a non-constant growth rate.

Understanding Future Stock Value

There are many different ways to appraise the future value of stocks, including fundamental criteria and stock valuation methods.


LEARNING OBJECTIVE

  • Describe different ways of valuing stock

KEY POINTS

    • Earnings Per Share is the total net income of the company divided by the number of shares outstanding; the Profits/Earnings ratio is the stock price divided by the annual EPS figure.
    • Return on Invested Capital measures how much money the company makes each year per dollar of invested capital and approximates the expected level of growth; Return on Assets measures the company's ability to make money from its assets.
    • To measure Market Capitalization (the value of all of a company's stock), multiply the current stock price by the fully diluted shares outstanding; Enterprise Value is equal to the total value the company is trading for on the stock market.
    • Enterprise Value (EV) to earnings before interest, taxes, depreciation and amortization (EBITDA) is one of the best measurements of whether or not a company should be valued as cheap or expensive.

TERMS

  • GAAP

    Generally Accepted Accounting Principles refer to the standard framework of guidelines, conventions, and rules accountants are expected to follow in recording, summarizing, and preparing financial statements in any given jurisdiction.

  • risk premium

    A risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset, or the expected return on a less risky asset, in order to induce an individual to hold the risky asset rather than the risk-free asset.

EXAMPLE

    • P/E Ratio: For example, if the stock is trading at 10 and the EPS is 0.50, the P/E is 20 times. To get a good feeling of what P/E multiple a stock trades at, be sure to look at both the historical and forward ratios.


In financial markets, stock valuation involves calculating theoretical values of companies and their stocks. The main use of stock valuation is to predict future market prices and profit from price changes. Stocks that are judged as undervalued (with respect to their theoretical value) are bought, while stocks that are perceived to be overvalued are sold, in the expectation that undervalued stocks will, on the whole, rise, while overvalued stocks will, on the whole, fall. Stock valuation involves many methods.


Fundamental Criteria (Fair Value)

The soundest stock valuation method, the discounted cash flow (DCF) method of income valuation, involves discounting the profits (dividends, earnings, or cash flows) the stock will bring to stockholders in the foreseeable future, and calculating a final value on disposal. The discounted rate normally includes a risk premium which is often based on the capital asset pricing model.


Stock Valuation Methods

There are many different ways to value stocks. The key is to take each approach into account while formulating an overall opinion of the stock. If the valuation of a company is lower or higher than other similar stocks, then the next step would be to determine the reasons for the discrepancy.


1. Earnings Per Share (EPS)

EPS is the total net income of the company divided by the number of shares outstanding. Numbers are usually reported as a GAAP EPS number (which means it is computed using mutually agreed upon accounting rules) and a Pro Forma EPS figure (income is adjusted to exclude any one time items as well as some non-cash items like amortization of goodwill or stock option expenses).

2. Price to Earnings (P/E)

Once one has several EPS figures (historical and forecasts), the most common valuation technique used by analysts is the price to earnings ratio, or P/E. To compute this figure, the stock price is divided by the annual EPS figure.

3. Price Earnings to Growth (PEG) Ratio

This valuation technique has become more popular over the past decade or so. It is better than just looking at a P/E because it takes three factors into account: the price, earnings, and earnings growth rates. To compute the PEG ratio, divide the Forward P/E by the expected earnings growth rate (historical P/E and historical growth rate are also used to see where the stock has traded in the past).

4. Return on Invested Capital (ROIC)

This valuation technique measures how much money the company makes each year per dollar of invested capital. Invested capital is the amount of money invested in the company by both stockholders and debtors. The ratio is expressed as a percent and Return on Invested Capital ratio should have a percent that approximates the expected level of growth. In its simplest definition, this ratio measures the investment return that management is able to get for its capital. The higher the number, the better the return.

5. Return on Assets (ROA)

Similar to ROIC, ROA, expressed as a percent, measures the company's ability to make money from its assets. To measure the ROA, take the pro forma net income divided by the total assets. However, because of very common irregularities in balance sheets(due to things like goodwill, write-offs, discontinuations, etc. ) this ratio is not always a good indicator of the company's potential. If the ratio is higher or lower than expected, be sure to look closely at the assets to see what could be overstating or understating the figure.

6. Price to Sales (P/S)

This figure is useful because it compares the current stock price to the annual sales. In other words, it tells you how much the stock costs per dollar of sales earned.

7. Market Cap

Market Cap, which is short for Market Capitalization, is the value of all of the company's stock. To measure it, multiply the current stock price by the fully diluted shares outstanding.

8. Enterprise Value (EV)

Enterprise Value is equal to the total value of the company, as trading on the stock market. To compute it, add the Market Cap (see above) and the total net debt of the company.

9. EBITDA

EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is one of the best measures of a company's cash flow and is used for valuing both public and private companies.

10. EV to EBITDA

This is perhaps one of the best measurements of whether or not a company should be valued as cheap or expensive. To compute, divide the EV by EBITDA (see above for calculations). The higher the number, the more expensive the company is.