Tuesday, 9 September 2014

Stocks Valuation Methods

There are many ways to valuate a stock or investment. I search the internet and here are what I found and learned so far.

Stock valuation involves basically fundamental analysis. Some might say that technical analysis can be used to valuate a stock but I think it is more like to valuate stock price.

Whether it is fundamental or technical, there is no right or wrong as long as you know crystal clear what you are doing. Investors should find out themselves what really suit them.

For me, I believe that fundamental is the way to go.




Valuation methods from fundamentals can be divided into two groups:
  • Absolute valuation method
    • To find out the intrinsic (true) value of a company, and no need to compare with others
    • Eg. dividend discount model, discounted cash flow model, assets based model etc
  • Relative valuation method
    • To compare companies in the same sector, to find out which is more "undervalued" relative to others
    • Eg. P/E ratio, P/B ratio, PEG ratio, ROE, ROA, ROIC, EVM etc


Absolute valuation method

Dividend Discounted Model (DDM)
  • Basis: Dividend represents actual cash flow that will return to shareholders from an investment, ie. we put in our money and get our return in the form of dividend.
  • DDM uses predicted dividend growth rate to arrive at a present stock value
  • Only suitable for companies that pay consistent dividends
  • Dividends payout should be stable and predictable
  • Formula:


Discounted Cash Flow (DCF)
  • Basis: Free cash flow (FCF) represents actual return to shareholders from an investment
  • DCF uses future FCF projections and discounts them to arrive at a present value
  • FCF should be positive and predictable (not so suitable for growth companies with large capex)
  • Formula:


Net-net / Net Current Assets Value (NCAV)
  • Basis: Valuate a company solely on its net current assets
  • Introduced by Benjamin Graham
  • Formula


Book Value / Net Tangible Assets (NTA)
  • Basis: Valuate a company base on its net assets
  • Some investors include & some exclude intangible assets
  • Book value  = Total Assets - (Intangible Assets) - Total Liabilities
  • Book value should be compared to share price


Revalued Net Assets Valuation (RNAV)
  • Basis: Valuate a company base on market value of its assets such as land, buildings, business, investment etc.
  • Total market value of assets divided by outstanding shares to get RNAV per share.
  • Commonly used for property stocks

       Example of RNAV


There is another valuation method which is commonly mentioned when I read analyst reports, which is the Sum-Of-Parts valuation (SOP).

Sounds like Son-Of-XX?

It is suitable for companies with 2 or more business divisions, in which every divisions are valuated separately and then combined. The valuation method used for each divisions can be different.

I think it is best explained with example (by MIDF Research)

       Example of SOP Valuation

According to experts, there is no single best valuation method. However, some method may be more suitable for certain types of companies or businesses.

As many of those valuation methods are base on assumption and prediction of future earning, future cash flow, future dividend etc, it may not be very accurate.

Thus, investors usually set a discount rate or margin of safety to minimize the downside risk when making an investment.

For example, if you calculate a company to have an intrinsic value of RM1, and set a margin of safety of 30%, then it means you will buy if the stock price is 70sen or below.

Similarly analysts will always give a discount rate to RNAV of a property stock.

Finding the intrinsic value using DDM and DCF is not that simple actually. There are more complicated calculation and models that branch out from it. They are just too complicated for me to understand.

These are all what I know so far. Surely there are many other valuation methods not mentioned here. If there are any mistakes please feel free to correct me.

6 comments:

  1. Epic Research chooses the best method to evaluate the stocks. It results in high accuracy level.

    ReplyDelete
  2. Besides these methods that we can calculate, the other important factors are like good management team & future prospects of the business. Putting all these together to get maximal return :)

    ReplyDelete
    Replies
    1. Yea, both these are equally important.

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  3. for DDM, it should be next year dividend instead of current dividend.

    ReplyDelete
    Replies
    1. Thanks for pointing this out. I'm not too sure actually and have not use DDM so far. I think you're right.

      Delete
  4. As we are aware with the fact that stock valuation involves basically fundamental analysis as by the Epic research Private Limited.

    ReplyDelete