Stock valuation can be as simple or as complicated as we like. But let’s start with something you’ll likely find intriguing.
There’s no such thing as a “correct” / “true” value.
Despite what anyone might tell you, the fact is there really is no such thing as a “true” or “perfectly correct” stock valuation. The best we can do is get to a ‘reasonable estimate’.
That’s ultimately because valuation (note, not just stock valuation) is:
- Context dependent, and
- Preference dependent.
Let’s consider an example.
Imagine you own a business which generates a substantial amount of revenue each year.
The specific revenue figure can be whatever you fancy, but it’s a good idea to think of some revenue figure.
How much would you be willing to sell this amazing business for?
It’s a good idea to pause for a bit and just think about how much you’d be willing to sell your business for. And if you do actually own a business, it’s worth thinking about how much you want to sell it for.
Got a figure? Great.
Now consider this.
Imagine that the business still exists.
But it’s not you who owns it.
And you don’t want to sell the business; you want to buy it.
How much would you be willing to pay for this amazing business?
Chances are, the amount you’re willing to buy it for is considerably – if not substantially – lower than what you’re willing to sell it for.
And that’s precisely the point!
Valuation is subjective! It’s context, and preference dependent.
Generally speaking, sellers will tend to value their assets higher than buyers of the same assets.
How do we decide what’s a “reasonable” value?
Ultimately, in the context of stock valuation, the “reasonability” of an estimate is based on:
- The need, and
- The believability of the ‘story’.
What do we mean by “need”?
“Need” refers to the sort of context – the rationale / reason – for conducting the stock valuation exercise to begin with.
If for whatever reason, you desperately need to sell your business, then you’ll likely get a raw deal.
If on the other hand, you have plenty of time, and have several prospective buyers for your business, then you’ll likely get a much better deal.
That’s as far as the “need” side of the story goes. But what determines the believability?
We use numbers, math, and logic to determine the ‘believability’.
While stock valuation is subjective, fortunately, we have some techniques that help us bring in objective metrics and combine them with useful subjective proxies. The specific numbers and equations we use vary depending on the model you’re working with.
Interpreting the ‘story’
If the market price of the asset is greater than what the ‘story’ suggests, we think of the asset as ‘overvalued’. If on the other hand, the market price is lower than what the story suggests, then we say the asset is ‘undervalued’. Lastly of course, if the market price of the asset is equal to what the story suggests, then we say the asset is fairly priced.
We define the value based on the ‘story’ as the “intrinsic price” or “intrinsic value”.
The intrinsic value is the price / value at which the asset should be trading at, based on its firm fundamentals.
How do we get to the “intrinsic value”?
Broadly speaking, while there might well be hundreds if not thousands of different “models” to get to the intrinsic value, all stock valuation models can be grouped into:
- Discounted Cashflow (DCF) techniques
- Relative valuation techniques (aka Multiples valuation, Comparables valuation, “Comps” valuation), and
- Contingency based techniques (e.g. with Options).
Regardless of which model / approach you use, you’ll ultimately have your version of the ‘story’. You’ll then compare your ‘story’ with that of the market and make some conclusions.
Do you want to build your own stock valuation system?
- Explore stock valuation with real world data.
- Apply robust techniques, backed by research.
- Push the boundaries on Excel® and Google Sheets.
Get lifetime access to over 4 hours of HD video content, 100+ quiz questions with impeccably detailed solutions, plus assignments that push you outside your comfort zone.
Stock valuation using Discounted Cashflow (DCF)
Discounted cashflows are simply future cashflows discounted back (or ‘brought back’) to the present day (i.e., to their “Present Value”).
In other words, it’s a case of seeing how much money in the future is worth to us today, right here, right now.
The mechanics of this involves using a “discount rate” (aka Cost of Capital, Opportunity Cost of Capital, Hurdle Rate, Required Rate). This discount rate incorporates two key risks including:
- Firm specific risk, and
- Market risk (aka ‘Systematic’ risk).
The value of a stock is then equal to the “Present Value” of its future cashflows.
Stock valuation using Multiples
An alternative approach is to work with “Multiples”. This approach is also called “Relative Valuation” or “Comparables Valuation”, or just “Comps Valuation”.
The idea’s to value a stock based on what its comparable firms are worth.
Intuitively, if your neighbour’s house is worth $482,529 then it’s likely that your house will be worth somewhere in that ballpark. It’s unlikely that your house will be worth $100,000 for instance. Or even $2,000,000 for that matter.
This technique is probably the easiest one out there. The trick of course, and the challenge, is in knowing how to find the right comparable firm.
Just like real estate, stocks too have ‘neighbours’. It’s just that they’re not physically located next to each other. So we rely on and use robust “matching” techniques to find the right comparable firm.
And the valuation estimate you come up with really does depend on how good the comparable firm is.
Contingency based stock valuation
Last, but certainly not the least, we can value stocks using Options. This approach is essentially about “reverse engineering” the price. That’s because the value of an option is based on the value of a stock. And that is because options are “derivatives” in that they derive their value from an underlying security – in this case, stocks.
So if you know the value of an option, you can “reverse engineer” it to obtain the value of a stock!
Justifying the purpose of stock valuation
Notwithstanding the importance of any of the concepts we’ve covered above, it’s important to consider whether or not carrying out a valuation exercise is justified.
And this really depends on whether you believe in “efficient markets” or not.
If markets are “efficient”, it means that the prices of all securities reflect all the available information out there. By definition, that would mean that the stock price you see on a platform like Yahoo! Finance or the FT is the correct price / correct value.
And if it’s the “correct” price, then there’s no point in carrying out a valuation (because you can just see the price online!).
By attempting to value any stock, by picking up a calculator, or opening an Excel® spreadsheet, you implicitly imply that you do not believe markets are efficient.
And that is okay, despite what the folks in Asset Pricing will tell you!