In the immortal words of Warren Buffet, “Price is what you pay, value is what you get.” To determine the price of a stock, you can quickly search the internet. There is even an app for that (actually, many). To determine stock valuation is the more challenging part.
The first step in stock valuation is to understand is your role as a stockholder. Shares of stock represent ownership in the underlying company. For instance, if you own a share of Tesla, you own a portion of Tesla, Inc. Owning a share of Tesla stock also makes you Elon Musk’s boss!
One of the most important aspects of stock valuation is understanding the business you’re investing in. Since you own the company, you should know as much about it as possible. Armed with this knowledge, you can begin the stock valuation process.
The thing to remember about the stock market is that investors can buy or sell stocks for whatever reason they want. Therefore, stock prices can fluctuate much higher or lower than their intrinsic value in the short term. After you identify a company you like, the goal is to buy shares at a much lower price than what you think the shares are worth (known as Intrinsic Value).
The company will publish press releases and file financial results as time goes on. Eventually, the shares will gravitate toward their intrinsic value.
How do I estimate intrinsic value? Investors use many stock valuation metrics to estimate a stock’s intrinsic value.
Stock Valuation Metrics
One of the most commonly cited stock valuation metrics is the Price-to-Earnings Ratio or P/E Ratio. It can help you determine if a share is a good investment compared to a similar company’s P/E Ratios. Also, you can compare the stock’s current P/E ratio to the stock’s long-term average P/E ratio.
Suppose the P/E ratio is below the P/E ratio of other similar companies. In that case, it is ‘cheap.’ A cheap stock is one whose shares might be a good investment. Suppose the P/E ratio is above similar companies or its average P/E. In that case, it might be ‘expensive.’ An expensive stock is one whose shares are not likely a good investment.
To put the P/E ratio in perspective, the long-term average P/E ratio for stocks in the S&P 500 index is around 16.
Another good stock valuation metric is its Price-to-Book Ratio or P/B Ratio. Like P/E, it can help you determine if a share is cheap or expensive compared to similar companies or its long-term average.
A more complicated stock valuation metric is Discounted Cash Flow. First, an investor should estimate a company’s future annual cash flow. Next, an investor should discount those future estimates to their value in today’s dollars (or present value).
The intrinsic value that you determined using the Discounted Cash Flow Model can be compared to the current stock price to determine if the shares are cheap or expensive.
Wait. How does all this work? What numbers should you use in these stock valuation formulas? Which stock valuation metrics should you use?
Stock Valuation Formulas
Here are a couple of things before we dive in. First, each company’s earnings and book value are available in their quarterly (10-Q) and annual (10-K) SEC filings. Those filings are public on the SEC website. Most stock companies also post SEC filings on the Investor Relations page of their websites.
Also, there are advantages and disadvantages to each stock valuation metric. In addition, each stock valuation metric might work better with different types of companies. Remember, understanding the business is very important.
Price-to-Earnings Ratio
The ‘P’ is the price of each share, and the ‘E’ is its earnings per share (EPS). You divide the company’s annual earnings by the number of shares outstanding. Divide ‘P’ by ‘E,’ and you’ve got your P/E ratio.
- Advantages: Investors widely use the P/E ratio. The ratio makes comparisons more informative.
- Disadvantages: Both the price and EPS can change over time.
- When to use it: The P/E Ratio works best when EPS is stable over time.
Price-to-Book Ratio
Again, the ‘P’ is simply the price of each share. The ‘B’ is the book value per share. Book Value is the assets of a company minus its liabilities. Found on the company’s balance sheet, book value is is also known as equity. Divide the equity by the number of shares outstanding to determine ‘B.’ Divide ‘P’ by ‘B,’ and you’ve got your B/V ratio.
- Advantages: P/B is also widely used. It is also very intuitive. For instance, equity in a business is the same as equity in your home. If you sell your home and pay off the mortgage, equity is the value that remains. You’re left with equity if you sold all a company’s assets and paid off the liabilities.
- Disadvantages: Some assets might be worth more or less than the amount the company reports on the balance sheet. Sometimes, the value of assets may change over time.
- When to use it: P/B is great for companies with assets that are easier to value. The assets on the balance sheet of a bank stock are typically reliable. Real Estate companies are another example.
Keep reading for more information on stock valuation.
Discounted Cash Flow
It is essential to be confident in your cash flow estimates. The Discounted Cash Flow Model requires some guesswork on your part. Investors using the Discounted Cash Flow Model will often make both optimistic and pessimistic cash flow estimates.
After making your estimates, plug each one into the present value formula. After that, add them up and divide by the number of shares outstanding. An Excel spreadsheet can be very helpful when using this method.
- Advantages: The Discounted Cash Flow Method will give you the most accurate estimate of intrinsic value when done well. In addition, the model does not require comparisons.
- Disadvantages: Future cash flow estimates can be challenging to estimate.
- When to use it: You can use this method with any company. Just make sure you know the company well and are honest with your estimates.
Putting It All Together
To be a great investor, you also need to be patient. Patients are required not only to wait for shares to become cheap. Patients are also required to wait for the price to gravitate to its intrinsic value. The whole process will take years! Great investors have a knack of using stock valuation metrics to estimate intrinsic value.
In addition, the intrinsic value of genuinely outstanding companies will also move up over time! A handsome reward for all your hard work and patience.