Methods of Stock Valuation
Shares of stock represent ownership stakes in companies. Valuing individual shares requires understanding the value of the business enterprise as a whole. Methods for valuation generally fall into two categories: comparative valuation and theoretical valuation.
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Significance
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With the increase in ownership of stock by individuals during the past three decades, the importance of understanding how stocks are priced has grown significantly. Many people own stocks in their 401(k) plans and as such rely on how they are priced for future retirement income. Educational endowments often invest in corporate stocks as a way to build value over time. Also, more and more parents are investing in 529 plans for their children to fund future educational costs, and these plans invest in stock.
Comparative Valuation
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Perhaps the most common-sense approach to valuing a particular stock is very similar to how homes are priced in neighborhoods. When houses are sold in a particular area, the prices they fetch influence the valuation of similar homes in the same area. This comparable valuation approach can be used to value stocks. The first step is to make a list of companies that are similar to the company that is being valued, in terms of industry, products and size. As long as the companies selected are public, with stock prices of their own trading on a daily basis on a stock exchange, then their valuations can be applied to the sales, cash flow, assets and book value of the company being valued to see where they fall in relation to their comparable or peer companies.
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Comparative Transactions
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A more specific use of the comparative approach is to look for mergers, divestitures and acquisitions of companies that are similar to the company under evaluation. The price paid in such transactions can be used to determine dollar multiples paid for such metrics as sales, cash flow, assets and book value. Applying these multiples to the firm's own metrics determines its comparative value. After subtracting the company's total debt, the remaining equity value is then divided by the number of shares of stock to get to a per share stock value.
Theoretical Valuation
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A more sophisticated approach to valuing stocks is to construct a financial model of the company being evaluated using spreadsheets. As much detail as possible should be included about the firm's revenues, expenses, taxes and financing costs to create as model of the cash flows that it will generate into the future. By discounting these cash flows back to the present time using a discount rate that estimates the firm's cost to borrow money and raise new equity, the present value of the firm's future cash production can be determined. This value divided by the number of shares outstanding yields the per share price.
Benefits
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The benefit to valuing stock prices is to take an active role as a shareholder in a company. By thinking through the processes outlined in both comparative and theoretical valuation, an investor can be more proactive in how his money is invested.
Warning
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Individual investors compete with professional analysts when they value shares of stock. Professional investors will always have more time, expertise, information and experience than the typical private investor. It is therefore very difficult to do a better job of valuing stocks than a professional analyst.
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