Stock Valuation Methods: A Beginner’s Guide to Intrinsic Value

When it comes to stock valuation, remember this simple principle: price is what you pay, but value is what you get.

Stock prices move up and down every day. Sometimes they rise because of good news. Sometimes they fall because of fear or uncertainty. These short-term price changes do not always reflect what a company is really worth.

That is where stock valuation comes in. It helps investors estimate a company’s true value. It also provides an objective way to decide whether a stock is undervalued, overvalued, or fairly priced.

In this article, we’ll cover the two primary approaches to stock valuation:

• Absolute Valuation
• Relative Valuation

At the core of the stock valuation process is determining the fair value of an asset, company, or project. This process requires analyzing a company’s financial statements, understanding market trends, and applying appropriate valuation methods. Valuation is more than just working with numbers. It involves interpreting financial data to assess a business’s current performance and its future potential.

The valuation process begins with a review of the three primary financial statements: the income statement, balance sheet, and cash flow statement. These statements provide a comprehensive view of a company’s financial health. They also serve as the foundation for financial modeling, which is the process of building a financial representation of a company’s performance. By analyzing these components, analysts can forecast future financial performance, evaluate different scenarios, and assess the impact of strategic decisions.

1st Stock Valuation Method | Absolute Valuation:

This approach estimates a company’s true value based on its financial performance. Instead of comparing the company to other businesses, it focuses on the company’s ability to generate profits and cash over time.

Discounted Cash Flow (DCF):

This method estimates a company’s value by calculating the present value of its future cash flows. Since money today is worth more than the same amount in the future, those future cash flows are “discounted” back to their present value.

Example: Let’s assume your company is expected to generate $10 million in cash next year. Since that money will be received in the future, we need to determine the present value of this money. In this case, we will use the DCF model, which discounts future cash flow to determine its present value.

The meaning of discounted value: A lot can happen in a year. The economy might run into trouble, or the economy could tank. That future $10 million isn’t 100% guaranteed. Because of this risk, that future $10 million is worth a bit less to you right now. Let’s say, in today’s money, it feels like more than $9.5 million. That $9.5 million is the “discounted” value.

A Discounted Cash Flow (DCF) model is just a financial calculator that does this exact math over and over again. Using this method, the model calculates the present value of the company’s expected cash flow for each year. The model then adds all those shrunk, “today-value” numbers together. The final total is the intrinsic value. This reflects what the whole business is actually worth today based on the cash it is expected to generate in the future.

Dividend Discount Model (DDM):

A dividend discount model simply calculates the value based on expected future dividends. This model adopts the assumption that the company’s dividends represent the company’s cash flow to its shareholders.

A Real-World Example:

Let’s assume Coca-Cola is currently paying an annual dividend of $2.00 per share. As long as they are a massive, established company, they promise to increase the dividend by 4% every single year to keep up with inflation.

As an investor, you see that you need a 9% total return on your money, a “required return,” due to the market risks. This is the bare minimum profit you need to justify taking a risk on this specific stock instead of putting your money somewhere completely safe, like a government bond. At this point, you need to know the intrinsic value of Coca-Cola’s stock. Let’s calculate it using the DDM formula:

Stock Value = Next Year’s Expected Dividends / (Your required Return – Dividend Growth Rate)

• Next year’s dividend: $$2.00 x 1.04 = $2.08 (we considered the 4% annual increase)
• Your required return is 9%
• The growth rate is 4%

After the calculation, the intrinsic stock value is $41.60. If the stock is currently trading in the market for $35.00, it’s undervalued. You should buy it. If the stock is trading at $50.00, it’s overpriced (overvalued) based on the dividends it provides, so you might want to pass.

Now that you’ve learned what the absolute valuation that adopts DCF and DDM is, let’s move to the second stock valuation method, which is called the relative method or the multiplier approach.

2nd Stock Valuation Method | Relative Valuation (The Multiplier Approach):

Unlike absolute valuation, which estimates a company’s intrinsic value, relative valuation determines a company’s worth by comparing it with similar businesses in the same industry. The idea is simple: if two companies have similar operations, growth prospects, and risk profiles, they should be valued similarly. If one company trades at a much higher or lower valuation than its peers, it may be overvalued or undervalued.

One of the most common relative valuation methods is Comparable Company Analysis (Comps). Analysts compare a company’s valuation multiples with those of similar companies to identify pricing differences. Two of the most widely used multiples are the following:

• Price to Earnings (P/E) Ratio: Compares a company’s stock price to its earnings per share. It is best used when evaluating companies with consistent profits and is a useful measure of bottom-line earnings.
• Enterprise Value-to-EBITDA (EV/EBITDA): Compares a company’s total value, including debt, to its operating earnings before interest, taxes, depreciation, and amortization. Because it accounts for debt, this multiple is useful when comparing companies with different capital structures.

The biggest advantage of relative valuation is its simplicity. It is quick to calculate and reflects current market sentiment. However, it also has a major limitation. If the entire industry is overvalued or undervalued, relative valuation will likely reflect those same pricing distortions. In other words, comparing one expensive company to another expensive company does not necessarily reveal its true intrinsic value.