A beginner’s guide to stock valuation
How do you work out which stocks represent sensible long-term investments? Navexa's Navarre Trousselot dives into the world of valuing potential investments on the stock market.
With more than 2,200 listings on the ASX, how do you choose a single stock to invest in?
For many of us — especially those of us who hunt for value over the long term — the process begins with valuing a company whose shares trade on the stock market.
It won’t come as a surprise that there are many ways to go about valuing a company.
We all approach investing and building wealth in our own way.
Just as some investors look for high potential growth stocks that could explode hundreds of percent higher in a short time...
And others prefer to buy and hold large, relatively stable stocks for a long time...
There’s a variety of options available to you as you evaluate the value of a potential investment.
Here, we explain a few of the main ones.
First, though ...
What does it mean to value a stock — and why should you do it?
When you buy shares, you own a fraction of the company whose stock you acquire.
This means that before you buy shares in it, it makes sense that you understand the business you’re buying into.
This, in turn, means you need to delve into the business’s finances.
The phrase ‘due diligence’ refers to this process.
If you don’t know what you’re buying into, then you’re not investing.
Your due diligence — the necessary research, in other words — is what differentiates a bet from an investment (which is still a risk, of course, but a calculated one).
Determining a business’s financial health allows you to understand whether or not its share price accurately reflects the company’s value.
The stock market is seldom a perfect reflection of the value of the companies trading shares on it.
After all, everyone in the market is looking for opportunities to make money by speculating on the future.
This means that a company’s shares can easily trade below or above the ‘true’ value of the business they represent.
This is where valuing a stock gets interesting.
Popular ways of valuing a stock
The simplest measure investors use when trying to get a handle on a stock’s value is the price to earnings ratio, or P/E ratio.
The P/E ratio is the current share price divided by what the company earned for every share over the past year.
Generally speaking, the higher the P/E ratio, the more overvalued you might say a company’s shares are.
A lower P/E, on the other hand, might indicate the market undervalues the shares relative to the overall health of the business.
Other common ways to approach valuation include:
Cash flow: While a stock might not be getting much love from investors and trading cheap, you might fight when you dig into their financials that the business has a strong cash flow (that they make a good return on their spending, in other words). This could be an indicator that the share price will rise higher as the market notices the business making more money in the future.
Debt ratio: Work out how much money the businesses owes to others. Low debt, generally speaking, is a positive sign that a company is healthy and its stock price may rise in the future.
Assets/liabilities: Another helpful ratio to deploy in valuation research is assets/liabilities. This is exactly what is sounds like. Divide the value of the company’s assets by the value of its liabilities. The higher the ratio, the better.
Using Navexa’s Built-In Value Calculator
There are, as they say, many ways to skin a cat.
When it comes to valuing a stock, there’s a huge array of ratios, calculations and methods available to help you get an idea of where a company’s shares are trading relative to its ‘true’ value.
It’s up to you to find the method that best fits your investing style and wealth building goals.
But to make life a little easier for our users when they are trying to value a stock, we’ve built a simple value calculator into our portfolio tracker.
Our calculator uses the discounted cash flow method.
This method determines the value of an investment based on future cash flow.
It’s based partly on hard, current numbers, and partly on predicted or forecast future numbers.
This method is similar to what Warren Buffett uses to value a stock.
If the discounted cash flow works out to be higher than the current cost of the investment, this is an indication that the price could rise in the future.
It’s not guaranteed or 100% accurate. No method that estimates future events can be.
And it is just one of the ways to go about determining value when evaluating a stock.
We recommend you try different methods until you find one that suits you best.
Navarre is the Founder of Navexa — a portfolio analytics service made for Australian investors. Navarre left a lucrative corporate developer job to combine two of his passions; investing and entrepreneurship. He created Navexa because he couldn’t find a portfolio analytics service that met his own high standards. Now, he’s focused on helping as many Australians as possible get more from their portfolios through the smart and creative use of data. Follow Navarre on Twitter and connect with him on LinkedIn.
This article was originally published on https://www.navexa.com.au/blog/a-beginners-guide-to-stock-valuation