Here Are the Best Ways to Value a Stock
The stock market is an excellent place for you to make money and grow your wealth. A look at the Bloomberg Billionaires Index shows a list of the wealthiest people in the world. Most of these people made their fortune in the stock market. A person like Bill Gates is so wealthy because the stock of Microsoft has done well. You too can join the millions of Americans who invest in the stock market. In this article, we will look at the best ways to value a stock of a company.
Why Value a Stock?
A common question that is commonly asked is on the need for valuing a stock. The answer to this is relatively simple. Assume you are buying a piece of land and the seller asks for $100k. As a good buyer, you should not just pay the seller. Instead, you should do your research to find out whether that piece of land is of that price. The same is true with stocks investing. You value a stock to determine whether it is overvalued or not.
The first method of valuing a stock is to compare a number of ratios. The most common ratios are price-to-earnings (P/E), price-to-sales (P/S), enterprise value to earnings before interest, taxes, depreciation, and amortization (EV to EBITDA), and price to book value (P/BV).
The price to sales ratio measures the company’s current stock price with the sales. In this, investors can use the trailing twelve-month’s sales (TTM) or forward sales. Forward sales are derived from the company’s projections or the analysts’ expectation. The ratio is calculated by dividing the current market cap and these sales.
The PE ratio measures a company’s current stock price with the earnings per share. As with the PS ratio, this can either be forward or trailing. To calculate it, you divide the current stock price with the EPS.
The EV to EBITDA measures the company’s enterprise value with the EBITDA. The enterprise value is calculated by adding the market capitalization of the stock with the total debt minus cash. As such, the EV to EBITDA ratio is calculated by dividing the trailing or forward EBITDA with the current enterprise value.
After finding these ratios, you are then required to compare the numbers with the peer companies. This is because these ratios depend on the industry. For example, investors will always pay a premium for fast-growing technology companies like Twilio and Microsoft instead of the falling retail sector. Therefore, if you are valuing a technology company like Oracle, you need to compare its ratios with that of other old-tech companies like IBM, Cisco, Microsoft, and Apple. If the ratio of the company is lower than that of its peers, it can be said to be undervalued.
However, a common mistake many investors do is to invest in highly-undervalued companies. This is a mistake because the company is undervalued for a reason. For example, a tech company like IBM has a forward PE ratio of 9 while Microsoft has a forward PE ratio of 23 yet the two are competitors. This does not mean that IBM is a better investment than Microsoft. The reality is that IBM is undervalued because investors are worried about its debt and its future growth. Microsoft, on the other hand is growing so fast.
Discounted Cash Flow Method (DCF)
DCF is a popular method of valuing companies. The DCF method is used to value a company based on future cash flows. Cash flow is the net amount of cash and equivalents that are being transferred in and out of the company. A positive cash flow, also known as free cash flow indicates that the company’s liquid assets are increasing.
The DCF method is relatively challenging, especially for people without a background in finance. First, you need to have the company’s current cash flow. This can be levered or unlevered. You also need to estimate the amount the company will generate each year for about 10 years. Then, you need to establish a discount rate. With these, you can calculate the enterprise value by discounting the projected free cash flows and the total value. Finally, you calculate the value of the stock by subtracting the net debt from the enterprise value.
Technical analysis is a common method used to value a stock. Unlike the previous two, this method uses technical indicators to find whether a company is undervalued or overvalued. Several technical indicators can be used to value a stock. These are moving averages, relative strength index, stochastics, and Elliot Waves. For example, if a stock is trading at $20 and it’s short, medium, and long-term moving averages are above it, it can mean that the stock is undervalued. Second, if the stock’s RSI is at 20, it could mean that it is oversold, which is a bullish sign.
When making investment decisions, it is very important to know what you are getting. As such, valuation is so crucial because it can help you know whether you are overpaying or underpaying. However, as explain above, you need to be careful when making these decisions. For example, to invest in a company that is very undervalued, you need to have a catalyst that will take the stock price higher. Remember, when Sears went bankrupt, it had ultralow ratios.