Stock Valuation and Value Investing: A beginner's guide
Value investment is a time-tested strategy used by famous investors like Benjamin Graham and Warren Buffett who made most of their money through it. In this method, we determine the intrinsic value of a stock or a company to find out if the company is currently overvalued or undervalued. The process of finding the intrinsic value of a company is known as stock valuation. Let us understand more about stock valuation.
When it comes to stock marketing investing, the first thing that people might check is the share price or the market cap of the company. However, these metrics can be found through a simple Google search. Also, these are not definitive factors in determining the accurate worth of a company. The current share price simply indicates the price at which the share is currently being bought in the share market, and the market capitalisation refers to the total value of available shares.
Example: Calculating the market cap of TCS:
TCS's current share price = ₹4,361
TCS’s total number of shares = 3650709805
Its market capitalisation = Current share price x Total number of shares available in the market = ₹4,361 x 3650709805 = ₹ 15 Trillion
Unlike the market cap, the valuation of a company depends on several factors:
How the company is performing
How the sector is performing
What is the need for the product in the market
The excitement around the brand (or the lack of it)
Undervaluation vs Overvaluation
Overvaluation occurs when a stock’s current market price is higher than its intrinsic or true value. Investing in an overvalued stock can be risky, as its prices may eventually correct, leading to significant losses. Savvy investors typically look for signs of overvaluation to avoid these particular stocks.
Undervaluation, on the other hand, refers to when an asset's market price is lower than its intrinsic value. This can occur due to various factors, such as market inefficiencies, lack of investor awareness, or temporary setbacks in the company. This could even occur due to some abnormalities in the market. Investing in undervalued assets can offer significant profit opportunities, as their prices are likely to increase once the market recognises their true value. Value investors, such as Warren Buffett are known to seek out undervalued assets, believing they will generate substantial returns over the long term.
Methods of valuation:
There are two primary types of stock valuation methods:
Absolute Method
The absolute method of stock valuation relies on the fundamental analysis of the business you are thinking of investing in. One needs to go through the company’s balance sheets and find out certain metrics like cash flow, dividends and growth rate of the company. Here are some popular absolute valuation methods:
Dividend Discount Model (DDM)
The Dividend Discount Model (DDM) is a widely accepted method for calculating the intrinsic value of a stock. It determines the actual price of a stock based on the dividends a company pays to its shareholders. Analysts argue that dividends represent the true cash flow of a business to its shareholders, so calculating the present value of future dividend payments should reveal the correct worth of the stock.
Types of Dividend Discount Models
Gordon Growth Model (Constant Growth DDM): Assumes dividends will grow at a constant rate indefinitely.Multi-Stage DDM: Assumes different growth rates for different periods, often used for companies with varying growth phases.
The formula for the Gordon Growth Model:
The most commonly used version of DDM is the Gordon Growth Model, which is expressed as:
P0 = D1r-g
where:
P0 = Present value of the stock
D1 = Dividend expected next year
r = Required rate of return (discount rate)
g = Growth rate of dividends
Example: Applying the Gordon Growth Model
Let's consider a hypothetical company, XYZ Corp., to illustrate the DDM.
Step 1: Gathering information:
Current Dividend D0: $2.00 per share
Dividend Growth Rate (g): 5% per year
Required Rate of Return (r): 10%
Step 2: Calculate the Expected Dividend D1:
The dividend expected next year ( D1 ) is calculated by:
D1 = D0 x (1 + g)
D1 = 2.00 x (1+ 0.05)
D1 = 2.00 x 1.05
D1 = 2.10
Step 3: Apply the Gordon Growth Model Formula
Now, we can find the present value of XYZ Corp.'s stock using the formula:
P0 = D1r-g
P0 = 2.100.10 - 0.05
P0 = 2.100.05
P0 = 42.00
According to the Gordon Growth Model, the intrinsic value of XYZ Corp.'s stock is $42.00 per share.
Interpretation
If XYZ Corp.'s current market price is below $42.00, the stock may be undervalued, making it a potentially attractive investment opportunity. Conversely, if the market price is above $42.00, the stock might be overvalued.
Limitations of the Dividend Discount Model
The Gordon Growth Model assumes that dividends will grow at a constant rate indefinitely, which may not be realistic for all companies.
Not all companies pay dividends, especially newer or high-growth companies that reinvest earnings back into the business.
Estimating the appropriate discount rate can be challenging and subjective.
Discounted Cash Flow Model (DCF)
For companies that don’t pay dividends or have irregular dividend models, investors turn to the Discounted Cash Flow (DCF) model. This method calculates the value of a company. This flexibility makes it suitable for valuing non-blue-chip companies, providing a broader applicability than the DDM.
Steps to Calculate DCF:
Estimate future cash flows: Predict the cash flows the investment will generate in the future. This includes estimating the annual cash inflows and outflows.
Determine the discount rate: Choose an appropriate discount rate, usually the required rate of return or the cost of capital.
Calculate the present value of future cash flows: Discount the future cash flows back to their present value using the chosen discount rate.
Sum the present values: Add the present values of all the future cash flows to get the total value of the investment.
Example:
Let's say you're considering investing in a company. You estimate the following future cash flows and decide that a discount rate of 10% is appropriate.
Step 1: Estimate future cash flows
You have already estimated the future cash flows for each of the next five years.
Step 2: Determine the discount rate
The discount rate is 10%.
Step 3: Calculate the present value of future cash flows
To calculate the present value (PV) of each cash flow, use the formula:
PV = Future cash flow(1+Discount rate)n
Where n is the year in which the cash flow is received.
PV1 = 5,000(1+0.10)1 = 5,0001.10 = 4,545.45
PV2 = 6,000(1+0.10)2 = 6,0001.21 = 4,958.68
PV3 = 7,000(1+0.10)3 = 7,0001.331 = 5,260.03
PV4 = 8,000(1+0.10)4 = 8,0001.464 = 5,464.31
PV5 = 9,000(1+0.10)5 = 9,0001.6105 = 5,589.32
Step 4: Sum the present values
Now, add up all the present values:
Total PV = 4,545.45 + 4,958.68 + 5,260.03 + 5,464.31 + 5,589.32 = 25,817.79
The value of the investment, based on the DCF model, is $25,817.79. This means that, according to your estimates and the chosen discount rate, the present value of the expected future cash flows from this investment is $25,817.79.
Relative Method
The relative model works on comparing the ratios between companies to determine the true value of stocks. The following are some ratios used in the relative model of valuation:
P/E Ratio:
The P/E ratio compares a company's current share price to its earnings per share (EPS).
A high P/E ratio indicates overvaluation, whereas a low P/E ratio indicates undervaluation of the stock.
Compare the P/E ratio of the stock with the P/E ratios of other companies in the same industry or the overall market.
Example:
Let's say a company's stock is trading at $50 per share, and its EPS over the past year is $5.
P/E Ratio= 50/5= 10
This means investors are willing to pay $10 for every $1 of earnings. A high P/E ratio might indicate that the stock is overvalued, or investors are expecting high growth rates in the future. Conversely, a low P/E ratio might suggest the stock is undervalued or that the company is experiencing difficulties.
Price-to-Book (P/B) Ratio:
The P/B ratio compares a company's market value to its book value (value of assets - value of liabilities).
If the P/B ratio < 1, this might indicate the stock is undervalued, whereas the P/B ratio > 1 suggests the stock might be overvalued.
Again, compare the P/B ratio with other companies in the same sector.
Example:
Assume a company's stock is trading at $40 per share, and the book value per share is $20.
P/B Ratio= 40/20= 2
This indicates that investors are willing to pay $2 for every $1 of book value. A high P/B ratio might suggest that the stock is overvalued, while a low P/B ratio might indicate it is undervalued.
Understanding value investing:
Value investing is a strategy where investors seek to purchase stocks that are undervalued relative to their intrinsic value. The goal is to identify stocks that are trading below their true worth and hold them until the market recognises their value, leading to price appreciation.
Warren Buffett Case study:
Warren Buffett, CEO of Berkshire Hathaway, is one of the most successful value investors. Buffett's investment in Coca-Cola in 1988 is a prime example of value investing.
In 1988, Coca-Cola was facing challenges due to market saturation and competitive pressures. Despite these issues, Buffett saw the company's strong brand, consistent earnings, and global reach as indicators of long-term value.
Buffett used a combination of valuation methods, including P/E and DCF analysis, to determine that Coca-Cola was undervalued. At the time, Coca-Cola's P/E ratio was around 15, and its growth prospects were promising.
Buffett invested $1 billion in Coca-Cola, purchasing 6.3% of the company. Over the years, Coca-Cola's stock price increased significantly, and Buffett's investment grew in value.
Tips for Successful Value Investing
Patience is key: Value investing requires patience, as it may take time for the market to recognize a stock's true value.
Diversify: Spread your investments across different sectors and industries to reduce risk.
Stay disciplined: Stick to your investment strategy and avoid making impulsive decisions based on market noise.
Stock valuation and value investing are essential concepts for anyone looking to succeed in the stock market. By understanding different valuation methods and applying the principles of value investing, you can make informed decisions, manage risks, and maximize your returns. Remember, investing is a journey that requires continuous learning and adaptation. Use this guide as a starting point, and keep exploring the world of finance to enhance your investment skills.
Whether you are a beginner or an experienced investor, mastering the art of stock valuation and value investing can help you build a strong portfolio and achieve your financial goals.
Image credits:
Motely Fool, 2024
Wall Street Prep, 2024
USA Today, 2024
