Stock valuation

In financial markets, stock valuation is the method of 1.1 Stock valuation methods
calculating theoretical values of companies and their
stocks. The main use of these methods is to predict fu- Stocks have two types of valuations. One is a value cre-
ture market prices, or more generally, potential market ated using some type of cash flow, sales or fundamen-
prices, and thus to profit from price movement – stocks tal earnings analysis. The other value is dictated by how
that are judged undervalued (with respect to their the- much an investor is willing to pay for a particular share of
oretical value) are bought, while stocks that are judged stock and by how much other investors are willing to sell
overvalued are sold, in the expectation that undervalued a stock for (in other words, by supply and demand). Both
stocks will, on the whole, rise in value, while overvalued of these values change over time as investors change the
stocks will, on the whole, fall. way they analyze stocks and as they become more or less
In the view of fundamental analysis, stock valuation based confident in the future of stocks.
on fundamentals aims to give an estimate of the intrinsic The fundamental valuation is the valuation that people
value of a stock, based on predictions of the future cash use to justify stock prices. The most common example
flows and profitability of the business. Fundamental anal- of this type of valuation methodology is P/E ratio, which
ysis may be replaced or augmented by market criteria – stands for Price to Earnings Ratio. This form of valua-
what the market will pay for the stock, without any neces- tion is based on historic ratios and statistics and aims to
sary notion of intrinsic value. These can be combined as assign value to a stock based on measurable attributes.
“predictions of future cash flows/profits (fundamental)", This form of valuation is typically what drives long-term
together with “what will the market pay for these prof- stock prices.
its?" These can be seen as “supply and demand” sides –
The other way stocks are valued is based on supply and
what underlies the supply (of stock), and what drives the
demand. The more people that want to buy the stock,
(market) demand for stock?
the higher its price will be. And conversely, the more
In the view of others, such as John Maynard Keynes, people that want to sell the stock, the lower the price will
stock valuation is not a prediction but a convention, which be. This form of valuation is very hard to understand or
serves to facilitate investment and ensure that stocks are predict, and it often drives the short-term stock market
liquid, despite being underpinned by an illiquid business trends.
and its illiquid investments, such as factories.
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
1 Fundamental criteria (fair value) step would be to determine the reasons.

The most theoretically sound stock valuation method, 1.1.1 Earnings per share (EPS)
called income valuation or the discounted cash flow
(DCF) method, involves discounting of the profits EPS is the net income available to common sharehold-
(dividends, earnings, or cash flows) the stock will bring to ers of the company divided by the number of shares out-
the stockholder in the foreseeable future, and a final value standing. Usually there will be two types of EPS listed: a
on disposal.[1] The discounted rate normally includes a GAAP (Generally Accepted Accounting Principles) EPS
risk premium which is commonly based on the capital and a Pro Forma EPS, which means that the income has
asset pricing model. been adjusted to exclude any one time items as well as
In July 2010, a Delaware court ruled on appropriate in- some non-cash items like amortization of goodwill or
puts to use in discounted cash flow analysis in a dispute stock option expenses. The most important thing to look
between shareholders and a company over the proper for in the EPS figure is the overall quality of earnings.
fair value of the stock. In this case the shareholders’ Make sure the company is not trying to manipulate their
model provided value of $139 per share and the com- EPS numbers to make it look like they are more prof-
pany’s model provided $89 per share. Contested inputs itable. Also, look at the growth in EPS over the past sev-
included the terminal growth rate, the equity risk pre- eral quarters / years to understand how volatile their EPS
mium, and beta.[2] is, and to see if they are an underachiever or an over-

1
2 1 FUNDAMENTAL CRITERIA (FAIR VALUE)

achiever. In other words, have they consistently beaten culating the future growth rate requires personal invest-
expectations or are they constantly restating and lowering ment research. This may take form in listening to the
their forecasts? company’s quarterly conference call or reading a press
The EPS number that most analysts use is the pro forma release or other company article that discusses the com-
EPS. To compute this number, use the net income that pany’s growth guidance. However, although companies
excludes any one-time gains or losses and excludes any are in the best position to forecast their own growth, they
non-cash expenses like stock options or amortization of are often far from accurate, and unforeseen events could
goodwill. Then divide this number by the number of fully cause rapid changes in the economy and in the company’s
industry.
diluted shares outstanding. Historical EPS figures and
forecasts for the next 1–2 years can be found by visit- For any valuation technique, it is important to look at a
ing free financial sites such as Yahoo Finance (enter the range of forecast values. For example, if the company
ticker and then click on “estimates”). being valued has been growing earnings between 5 and
Through fundamental investment research, one can deter- 10% each year for the last 5 years, but believes that it will
mine their own EPS forecasts and apply other valuation grow 15 –20% this year, a more conservative growth rate
techniques below. of 10–15% would be appropriate in valuations. Another
example would be for a company that has been going
through restructuring. It may have been growing earn-
1.1.2 Price to Earnings (P/E) ings at 10–15% over the past several quarters or years
because of cost cutting, but their sales growth could be
Now that the analyst has several EPS figures (historical only 0–5%. This would signal that their earnings growth
and forecasts), the analyst will be able to look at the most will probably slow when the cost cutting has fully taken
common valuation technique used, the price to earnings effect. Therefore, forecasting an earnings growth closer
ratio, or P/E. To compute this figure, one divides the stock to the 0–5% rate would be more appropriate rather than
price by the annual EPS figure. For example, if the stock the 15–20%. Nonetheless, the growth rate method of val-
is trading at $10 and the EPS is $0.50, the P/E is 20 times. uations relies heavily on gut feel to make a forecast. This
A complete analysis of the P/E multiple includes a look is why analysts often make inaccurate forecasts, and also
at the historical and forward ratios. why familiarity with a company is essential before mak-
ing a forecast.
Historical P/Es are computed by taking the current price
divided by the sum of the EPS for the last four quarters,
or for the previous year. Historical trends of the P/E
should also be considered by viewing a chart of its his- 1.1.4 Price earnings to growth (PEG) ratio
torical P/E over the last several years (one can find this
on most finance sites like Yahoo Finance). Specifically This valuation technique has really become popular over
consider what range the P/E has traded in so as to de- the past decade or so. It is better than just looking at a
termine whether the current P/E is high or low versus its P/E because it takes three factors into account; the price,
historical average. earnings, and earnings growth rates. To compute the PEG
Forward P/Es reflect the future growth of the company ratio, the Forward P/E is divided by the expected earnings
into the future. Forward P/Es are computed by taking growth rate (one can also use historical P/E and historical
the current stock price divided by the sum of the EPS es- growth rate to see where it has traded in the past). This
timates for the next four quarters, or for the EPS estimate will yield a ratio that is usually expressed as a percentage.
for next calendar or fiscal year or two. The theory goes that as the percentage rises over 100%
the stock becomes more and more overvalued, and as the
P/Es change constantly. If there is a large price change PEG ratio falls below 100% the stock becomes more and
in a stock, or if the earnings (EPS) estimates change, the more undervalued. The theory is based on a belief that
ratio is recomputed. P/E ratios should approximate the long-term growth rate
of a company’s earnings. Whether or not this is true will
never be proven and the theory is therefore just a rule of
1.1.3 Growth rate
thumb to use in the overall valuation process.
Valuations rely very heavily on the expected growth rate Here is an example of how to use the PEG ratio to com-
of a company. One must look at the historical growth rate pare stocks. Stock A is trading at a forward P/E of 15
of both sales and income to get a feeling for the type of and expected to grow at 20%. Stock B is trading at a for-
future growth expected. However, companies are con- ward P/E of 30 and expected to grow at 25%. The PEG
stantly changing, as well as the economy, so solely us- ratio for Stock A is 75% (15/20) and for Stock B is 120%
ing historical growth rates to predict the future is not an (30/25). According to the PEG ratio, Stock A is a bet-
acceptable form of valuation. Instead, they are used as ter purchase because it has a lower PEG ratio, or in other
guidelines for what future growth could look like if simi- words, you can purchase its future earnings growth for a
lar circumstances are encountered by the company. Cal- lower relative price than that of Stock B.
1.1 Stock valuation methods 3

1.1.5 Sum of perpetuities method negative number indicates a valuation adjusted earnings
buffer. For example, if the 12 month forward mean EPS
The PEG ratio is a special case in the sum of perpetu- forecast is $10, the price of the equity is $100, the histor-
ities method (SPM) [3] equation. A generalized version ical average P/E ratio is 15, and the standard deviation of
of the Walter model (1956),[4] SPM considers the effects EPS forecast is 2, then the Nerbrand Z is −1.67. That is,
of dividends, earnings growth, as well as the risk profile 12 month forward consensus earnings estimates could be
of a firm on a stock’s value. Derived from the compound downgraded by 1.67 standard deviation before P/E ratio
interest formula using the present value of a perpetuity would go back to 15.
equation, SPM is an alternative to the Gordon Growth
Model. The variables are:
1.1.7 Return on Invested Capital (ROIC)
• P is the value of the stock or business
This valuation technique measures how much money the
• E is a company’s earnings company makes each year per dollar of invested capital.
Invested Capital is the amount of money invested in the
• G is the company’s constant growth rate company by both stockholders and debtors. The ratio is
• K is the company’s risk adjusted discount rate expressed as a percent and one looks for a percent that ap-
proximates the level of growth that expected. In its sim-
• D is the company’s dividend payment plest definition, this ratio measures the investment return
that management is able to get for its capital. The higher
the number, the better the return.
E∗G D To compute the ratio, take the pro forma net income
P =( )+( )
K2 K (same one used in the EPS figure mentioned above) and
divide it by the invested capital. Invested capital can be
In a special case where K is equal to 10%, and the com- estimated by adding together the stockholders equity, the
pany does not pay dividends, SPM reduces to the PEG total long and short term debt and accounts payable, and
ratio. then subtracting accounts receivable and cash (all of these
Additional models represent the sum of perpetuities in numbers can be found on the company’s latest quarterly
terms of earnings, growth rate, the risk-adjusted discount balance sheet). This ratio is much more useful when com-
rate, and accounting book value.[5] paring it to other companies being valued.

1.1.6 Nerbrand Z 1.1.8 Return on Assets (ROA)

Given that investments are subject to revisions of future Similar to ROIC, ROA, expressed as a percent, measures
expectations the Nerbrand Z utilises uncertainty of con- the company’s ability to make money from its assets. To
sensus estimates to assess how much earnings forecasts measure the ROA, take the pro forma net income divided
can be revised in standard deviation terms before P/E ra- by the total assets. However, because of very common ir-
tios return to normalised levels. This calculation is best regularities in balance sheets (due to things like Goodwill,
done with I/B/E/S consensus estimates. The market tends write-offs, discontinuations, etc.) this ratio is not always
to focus on the 12 month forward P/E level, but this ra- a good indicator of the company’s potential. If the ratio
tio is dependent on earnings estimates which are never is higher or lower than expected, one should look closely
homogenous. Hence there is a standard deviation of 12 at the assets to see what could be over or understating the
month forward earnings estimates. figure.
The Nerbrand z is therefore expressed as
1.1.9 Price to Sales (P/S)
P
H[P /E] − E12 This figure is useful because it compares the current stock
Z= price to the annual sales. In other words, it describes how
stdev(E12)
much the stock costs per dollar of sales earned. To com-
where H[P/E] = normalised P/E, e.g. a 5 year historical pute it, take the current stock price divided by the annual
average of 12 month forward P/E ratios. sales per share. The annual sales per share should be cal-
E12 = mean 12 month forward earnings estimates culated by taking the net sales for the last four quarters
divided by the fully diluted shares outstanding (both of
stdev(E12) = standard deviation of 12 month forward these figures can be found by looking at the press releases
earnings estimates. or quarterly reports). The price to sales ratio is useful,
A negative number indicates that earnings are likely to but it does not take into account any debt the company
be downgraded before valuations normalise. As such, a has. For example, if a company is heavily financed by
4 1 FUNDAMENTAL CRITERIA (FAIR VALUE)

debt instead of equity, then the sales per share will seem because it can easily be compared across companies, even
high (the P/S will be lower). All things equal, a lower P/S if not all of the companies are profitable.
ratio is better. However, this ratio is best looked at when
comparing more than one company.
1.1.14 EV to EBITDA

1.1.10 Market Cap This is perhaps one of the best measurements of whether
or not a company is cheap or expensive. To compute,
Market cap, which is short for market capitalization, is divide the EV by EBITDA (see above for calculations).
the value of all of the company’s stock. To measure it, The higher the number, the more expensive the company
multiply the current stock price by the fully diluted shares is. However, remember that more expensive companies
outstanding. Remember, the market cap is only the value are often valued higher because they are growing faster
of the stock. To get a more complete picture, look at the or because they are a higher quality company. With that
enterprise value. said, the best way to use EV/EBITDA is to compare it to
that of other similar companies.

1.1.11 Enterprise Value (EV)

1.2 Approximate valuation approaches
Enterprise value is equal to the total value of the com-
pany, as it is trading for on the stock market. To compute 1.2.1 Average growth approximation
it, add the market cap (see above) and the total net debt of
the company. The total net debt is equal to total long and Assuming that two stocks have the same earnings growth,
short term debt plus accounts payable, minus accounts the one with a lower P/E is a better value. The P/E
receivable, minus cash. The enterprise value is the best method is perhaps the most commonly used valuation
approximation of what a company is worth at any point in method in the stock brokerage industry.[6][7] By using
time because it takes into account the actual stock price comparison firms, a target price/earnings (or P/E) ratio
instead of balance sheet prices. When analysts say that is selected for the company, and then the future earnings
a company is a “billion dollar” company, they are often of the company are estimated. The valuation’s fair price
referring to its total enterprise value. Enterprise value is simply estimated earnings times target P/E. This model
fluctuates rapidly based on stock price changes. is essentially the same model as Gordon’s model, if k-g is
estimated as the dividend payout ratio (D/E) divided by
the target P/E ratio.
1.1.12 EV to Sales

This ratio measures the total company value as compared 1.2.2 Constant growth approximation
to its annual sales. A high ratio means that the company’s
value is much more than its sales. To compute it, divide The Gordon model or Gordon’s growth model[8] is the best
the EV by the net sales for the last four quarters. This ra- known of a class of discounted dividend models. It as-
tio is especially useful when valuing companies that do sumes that dividends will increase at a constant growth
not have earnings, or that are going through unusually rate (less than the discount rate) forever. The valuation is
rough times. For example, if a company is facing restruc- given by the formula:
turing and it is currently losing money, then the P/E ratio
would be irrelevant. However, by applying an EV to Sales
ratio, one could compute what that company could trade ∞ (
∑ )i
1+g 1+g
for when its restructuring is over and its earnings are back P =D· =D·
1+k k−g
to normal. i=1

and the following table defines each symbol:

1.1.13 EBITDA Dividend growth rate is not known, but earnings growth
may be used in its place, assuming that the payout ratio is
EBITDA stands for earnings before interest, taxes, depre- constant.
ciation and amortization. It is one of the best measures
of a company’s cash flow and is used for valuing both
public and private companies. To compute EBITDA, use 1.2.3 Limited high-growth period approximation
a company’s income statement, take the net income and
then add back interest, taxes, depreciation, amortization When a stock has a significantly higher growth rate
and any other non-cash or one-time charges. This leaves than its peers, it is sometimes assumed that the earnings
you with a number that approximates how much cash the growth rate will be sustained for a short time (say, 5
company is producing. EBITDA is a very popular figure years), and then the growth rate will revert to the mean.
 5

This is probably the most rigorous approximation that is Thus, in addition to fundamental economic criteria, mar-
practical.[9] ket criteria also have to be taken into account market-
While these DCF models are commonly used, the un- based valuation. Valuing a stock requires not just an
certainty in these values is hardly ever discussed. Note estimate its fair value, but also to determine its poten-
that the models diverge for k = g and hence are ex- tial price range, taking into account market behavior as-
tremely sensitive to the difference of dividend growth to pects. One of the behavioral valuation tools is the stock
discount factor. One might argue that an analyst can jus- image, a coefficient that bridges the theoretical fair value
tify any value (and that would usually be one close to and the market price.
the current price supporting his call) by fine-tuning the
growth/discount assumptions.
3 Keynes’s view
1.2.4 Implied growth models
In the view of noted economist John Maynard Keynes,
stock valuation is not an estimate of the fair value of
One can use the Gordon model or the limited high-growth
stocks, but rather a convention, which serves to provide
period approximation model to impute an implied growth
the necessary stability and liquidity for investment, so
estimate. To do this, one takes the average P/E and aver-
long as the convention does not break down:[10]
age growth for a comparison index, uses the current (or
forward) P/E of the stock in question, and calculates what
growth rate would be needed for the two valuation equa- Certain classes of investment
tions to be equal. This yields an estimate of the “break- are governed by the average ex-
even” growth rate for the stock’s current P/E ratio. (Note pectation of those who deal on the
: we are using earnings not dividends here because divi- Stock Exchange as revealed in the
dend policies vary and may be influenced by many factors price of shares, rather than by the
including tax treatment). genuine expectations of the profes-
sional entrepreneur. How then are
these highly significant daily, even
Imputed growth acceleration ratio Subsequently, hourly, revaluations of existing in-
one can divide this imputed growth estimate by recent vestments carried out in practice?
historical growth rates. If the resulting ratio is greater In practice, we have tacitly agreed,
than one, it implies that the stock would need to experi- as a rule, to fall back on what is, in
ence accelerated growth relative to its prior recent histor- truth, a convention. The essence of
ical growth to justify its current P/E (higher values sug- this convention – though it does not,
gest potential overvaluation). If the resulting ratio is less of course, work out so simply – lies
than one, it implies that either the market expects growth in assuming that the existing state
to slow for this stock or that the stock could sustain its of affairs will continue indefinitely,
current P/E with lower than historical growth (lower val- except in so far as we have specific
ues suggest potential undervaluation). Comparison of the reasons to expect a change.
IGAR across stocks in the same industry may give esti-
...
mates of relative value. IGAR averages across an industry
may give estimates of relative expected changes in indus- Nevertheless the above conven-
try growth (e.g. the market’s imputed expectation that an tional method of calculation will
industry is about to “take-off” or stagnate). Naturally, any be compatible with a considerable
differences in IGAR between stocks in the same indus- measure of continuity and stability
try may be due to differences in fundamentals, and would in our affairs, so long as we can rely
require further specific analysis. on the maintenance of the conven-
tion. …
Thus investment becomes reason-
2 Market criteria (potential price) ably 'safe' for the individual in-
vestor over short periods, and hence
over a succession of short periods
Some feel that if the stock is listed in a well organized however many, if he can fairly rely
stock market, with a large volume of transactions, the on there being no breakdown in
market price will reflect all known information relevant the convention and on his there-
to the valuation of the stock. This is called the efficient- fore having an opportunity to revise
market hypothesis. his judgment and change his invest-
On the other hand, studies made in the field of behavioral ment, before there has been time
finance tend to show that deviations from the fair price for much to happen. Investments
are rather common, and sometimes quite large. which are 'fixed' for the community
6 6 EXTERNAL LINKS

are thus made 'liquid' for the indi- [8] Corporate Finance, Stephen Ross, Randolph Westerfield,
vidual. and Jeffery Jaffe, Irwin, 1990, pp. 115-130.
— The General Theory, Chapter 12
[9] Discounted Cash Flow Calculator for Stock Valuation

[10] The Uncomfortable Dance Between V'ers and U'ers, Paul

4 See also McCulley, PIMCO

• Stock selection criterion • Stock valuation calculator by P/E values

• Bond valuation
• Real estate appraisal 6 External links
• Active portfolio management
• List of valuation topics
• Capital asset pricing model
• Value at risk
• Mosaic theory
• Fundamental analysis
• Technical analysis
• Fed model theory of equity valuation
• Undervalued stock
• John Burr Williams: Theory
• Chepakovich valuation model

5 References
[1] William F. Sharpe, “Investments”, Prentice-Hall, 1978,
pp. 300 et.seq.

[2] Delaware Provides Guidance Regarding Discounted Cash

Flow Analysis. Harvard Law School Forum on Corporate
Governance and Financial Regulation.

[3] Brown, Christian; Abraham, Fred (October 2012). “Sum

of Perpetuities Method for Valuing Stock Prices”. Journal
of Economics 38 (1): 59–72. Retrieved 20 October 2012.

[4] Walter, James (March 1956). “Dividend Policies and

Common Stock Prices”. Journal of Finance 11 (1):
29–41. doi:10.1111/j.1540-6261.1956.tb00684.x. Re-
trieved 20 October 2012.

[5] Yee, Kenton K., Earnings Quality and the Equity Risk
Premium: A Benchmark Model, Contemporary Account-
ing Research, Vol. 23, No. 3, pp. 833-877, Fall 2006 |
URL= http://papers.ssrn.com/sol3/papers.cfm?abstract_
id=921914

[6] Imam, Shahed, Richard Barker and Colin Clubb. 2008.

The Use of Valuation Models by UK Investment Analysts.
European Accounting Review. 17(3):503-535

[7] Demirakos, E. G., Strong, N. and Walker, M. (2004)

What valuation models do analysts use?. Accounting
Horizons 18 , pp. 221-240
 7

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