Trader’s Guide 1.6- Fundamental Value
Ways to Value a Company’s Stock
When it comes to investing in stocks, understanding how to value those stocks is crucial. After all, you want to make sure that you are getting a good deal on your investments and that you are buying into companies with strong potential for growth. In this chapter, we'll explore some of the key factors that go into stock valuations and how to use them to your advantage. We'll also delve into how to read and understand a company's balance sheet, and look at how to calculate the intrinsic value of a company using various financial metrics.
First, let's start with the basics of stock valuations. One of the most common ways to value stocks is through the use of price-to-earnings ratios, or P/E ratios. This ratio compares a company's current stock price to its earnings per share (EPS) and is used to gauge the company's profitability and potential for future growth. A high P/E ratio may indicate that a company's stock is overvalued, while a low P/E ratio may suggest that the stock is undervalued. It's important to note that P/E ratios can vary widely across different industries, so it's always a good idea to compare a company's P/E ratio to those of its peers in the same industry.
Another way to value stocks is through the use of earnings yield. Earnings yield is simply the inverse of the P/E ratio and is calculated by dividing a company's EPS by its stock price. A high earnings yield may indicate that a company's stock is undervalued, while a low earnings yield may suggest that the stock is overvalued.
In addition to P/E ratios and earnings yield, there are a number of other factors that can impact stock valuations. One of these is forward guidance, which refers to a company's outlook for future earnings and other financial performance indicators. If a company is providing strong forward guidance, it may signal to investors that the company has a bright future ahead and could lead to an increase in the stock's value. On the other hand, if a company is providing weak forward guidance, it may cause investors to lose confidence in the company and lead to a decline in the stock's value.
Another factor that can impact stock valuations is a company's cash flows. Cash flows refer to the amount of money that is coming into and going out of a company. Companies with strong cash flows are generally seen as being more financially stable and may be more attractive to investors. On the other hand, companies with weak cash flows may be seen as risky investments and may be less appealing to investors.
In addition to these factors, the rate of change of a company's revenues and earnings can also impact stock valuations. If a company is experiencing rapid revenue and earnings growth, it may signal to investors that the company has strong potential for future growth and could lead to an increase in the stock's value. On the other hand, if a company's revenues and earnings are declining, it may cause investors to lose confidence in the company and lead to a decline in the stock's value.
To calculate the rate of change of a company's revenues and earnings, you can use the following formula:
Rate of Change = (Current Period Value - Prior Period Value) / Prior Period Value
For example, let's say that a company's revenues in Q1 of the current year are $100 million and its revenues in Q1 of the prior year were $80 million. To calculate the rate of change of the company's revenues, you would use the following formula:
Rate of Change = ($100 million - $80 million) / $80 million = 0.25, or 25%
This means that the company's revenues have increased by 25% from the prior year.
Now, let's turn our attention to how to calculate the intrinsic value of a company. The intrinsic value of a company is an estimate of the company's true worth, based on its underlying financial and economic factors. There are several ways to calculate the intrinsic value of a company, but one common method is to use the discounted Cash Flow (DCF) model. This model estimates the value of a company by projecting its future cash flows and discounting them back to the present day using a required rate of return.
The equation for calculating the intrinsic value of a company using the DCF model is as follows:
Intrinsic Value = (Future Cash Flows / (1 + Required Rate of Return)) + Terminal Value
Where:
Future Cash Flows: The projected cash flows for a specific time period (usually 5-10 years)
Required Rate of Return: The minimum rate of return that investors expect for taking on the risk of investing in the company
Terminal Value: The estimated value of the company beyond the specific time period used in the calculation of future cash flows
For example, let's say that a company is projected to have cash flows of $100 million per year for the next 5 years, and the required rate of return is 10%. The terminal value of the company is estimated to be $500 million. To calculate the intrinsic value of the company, you would use the following formula:
Intrinsic Value = ($100 million / (1 + 0.10)) + $500 million = $454.55 million
This means that, based on the assumptions used in the calculation, the intrinsic value of the company is approximately $454.55 million.
Now, let's look at how to read and understand a company's balance sheet. A balance sheet is a financial statement that provides a snapshot of a company's financial position at a specific point in time. It includes information about the company's assets, liabilities, and equity. Assets are resources that the company owns and that have monetary value, such as cash, investments, and property. Liabilities are obligations that the company owes to others, such as loans and accounts payable. Equity represents the residual interest in the assets of the company after liabilities are paid.
To read a balance sheet, it's important to understand the difference between current and non-current assets and liabilities. Current assets are assets that are expected to be converted into cash or consumed within one year or the company's operating cycle (whichever is longer). Non-current assets are assets that are expected to be converted into cash or consumed after one year or the company's operating cycle. Current liabilities are obligations that are expected to be settled within one year or the company's operating cycle, while non-current liabilities are obligations that are expected to be settled after one year or the company's operating cycle.
The balance sheet is usually organized into two main sections: the assets section and the liabilities and equity section. The assets section lists the company's assets in order of liquidity, with the most liquid assets listed first. The liabilities and equity section lists the company's liabilities in order of maturity, with the most short-term liabilities listed first.
To get a sense of a company's financial health, you can look at its balance sheet and compare its assets to its liabilities and equity. If a company has more assets than liabilities and equity, it may be considered financially strong. On the other hand, if a company has more liabilities than assets, it may be considered financially weak.
In conclusion, understanding how to value stocks is crucial for any investor. By considering factors such as P/E ratios, earnings yield, forward guidance, company cash flows, and the rate of change of revenues and earnings, and by calculating the intrinsic value of a company using the DCF model, investors can make informed decisions about which stocks to buy and sell. It's also important to understand how to read and analyze a company's balance sheet to get a sense of its financial health. With the right knowledge and tools, investors can navigate the world of stock valuations and make informed investment decisions.
