In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued (with respect to their theoretical value) are bought, whereas stocks that are judged overvalued are sold, in the expectation that undervalued stocks will, on the whole, rise in value, while overvalued stocks will, on the whole, fall.
In the view of fundamental analysis, stock valuation based on fundamentals aims to give an estimate of their intrinsic value of the stock, based on predictions of the future cash flows and profitability of the business. Fundamental analysis may be replaced or augmented by market criteria – what the market will pay for the stock, without any necessary notion of intrinsic value. These can be combined as "predictions of future cash flows/profits (fundamental)", together with "what will the market pay for these profits"? These can be seen as "supply and demand" sides – what underlies the supply (of stock), and what drives the (market) demand for stock?
The most theoretically sound stock valuation method, called income valuation or the discounted cash flow (DCF) method, involves discounting of the profits (dividends, earnings, or cash flows) the stock will bring to the stockholder in the foreseeable future and a final value on disposal. The discounted rate normally includes a risk premium, which is commonly based on the capital asset pricing model.
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.
Earnings Per Share (EPS). EPS is the net income available to common shareholders of the company divided by the number of shares outstanding. They usually have a GAAP EPS number (which means that it is computed using all of mutually agreed upon accounting rules) and a Pro Forma EPS figure (which means that they have adjusted the income to exclude any one time items as well as some non-cash items like amortization of goodwill or stock option expenses). The most important thing to look for in the EPS figure is the overall quality of earnings. Make sure the company is not trying to manipulate their EPS numbers to make it look like they are more profitable. Also, look at the growth in EPS over the past several quarters / years to understand how volatile their EPS is, and to see if they are an underachiever or an overachiever. In other words, have they consistently beaten expectations or are they constantly restating and lowering their forecasts?
The EPS number that most analysts use is the pro forma EPS. To compute this number, use the net income that excludes any one-time gains or losses and excludes any non-cash expenses like stock options or amortization of goodwill. Then divide this number by the number of fully diluted shares outstanding. Historical EPS figures and forecasts for the next 1–2 years can be found by visiting free financial sites such as Yahoo Finance (enter the ticker and then click on "estimates).
Through fundamental investment research, one can determine their own EPS forecasts and apply other valuation techniques below.
Price to Earnings (P/E). Now that you have several EPS figures (historical and forecasts), you'll be able to look at the most common valuation technique used by analysts, the price to earnings ratio, or P/E. To compute this figure, take the stock price and divide it by the annual EPS figure. 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 the historical and forward ratios.
Discounted Cash Flow
Valuation using discounted cash flows is a method for determining the current value of a company using future cash flows adjusted for time value. The future cash flow set is made up of the cash flows within the determined forecast period and a continuing value that represents the cash flow stream after the forecast period.
Value of firm =
in which
Factors required for Discounted Cash Flow Analysis:
Example:
‘ABC’ is a medical ICT startup that has just finished their business plan. Their goal is to provide medical professionals with software solutions for doing their own bookkeeping. Their only investor is required to wait for five years before making an exit. Therefore ABC is using a forecast period of five years.
Example: ABC has chosen to use only operational cash flows in determining their estimated yearly cash flow: In thousand €
Example: ABC has chosen their discount rates based upon their company maturity.
Example:
Example: ABC has chosen the perpetuity growth model to calculate the value of cash flows after the forecast period. They estimate that they will grow at about 6% for the rest of these years.
(182*1.06 / (0.25-0.06)) = 1015.34 This value however is a future value that still needs to be discounted to a current value: 1015.34 * 1/(1.25)^5 = 332.72
Example: ABC doesn’t have any debt so it only needs to add up the current value of the continuing value and the current value of all cash flows during the forecast period:
62.14 + 332.72= 394.86. The equity value of ABC: € 394.86
Advantage of Discounted cash flow analysis:
Conclusion - Discounted Cash Flow model is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, terminal value techniques are often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on.
Eshna writes on PMP, PRINCE2, ITIL, ITSM, & Ethical Hacking. She has done her Masters in Journalism and Mass Communication and is a Gold Medalist in the same. A voracious reader, she has penned several articles in leading national newspapers like TOI, HT, and The Telegraph. She loves travelling and photography.
Financial Modeling with MS Excel Advanced
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