What is Stock Valuation? Advantages & Disadvantages

What is Stock Valuation? Factors & Methods of Stock Valuation

Stock trading in the market has a price that keeps changing as per the demand and supply among the traders or investors. From a technical perspective, there are various factors that affect the price of the stock, like market movement, level of volumes in trade and sentiments of the traders.

While, from a fundamental point of view, the fair valuation of the stock is an important factor that becomes the decision-making point to buy or sell the stock. Hence, you need to understand the stock valuation and the factors affecting the valuation of shares to determine the right valuation using the right methods of stock valuation. Let’s find out the stock valuation, how it is determined and why it is needed.

What is Valuation of Stock?

It is a process of determining the intrinsic value of a listed share or stock of a company. Various factors are considered while calculating the stock valuation to find out its fair price as per the company’s financial position. However, stock valuation helps to determine whether the stock is overvalued or undervalued.

And based on the fair valuation, the right investment decisions are made to buy the stock at the right price or when to book profit or exit from such investment. Stock valuation can be done using various techniques, but finding the intrinsic value of a stock is the main motive.

How Stock Value is Determined?

Though the demand and supply of the stock in the market are the main factor that determines the price. However, there are various other key factors like the company’s financial performance, industry trend, economic factor, monetary policy, and sentiment of the investors that affect the stock valuation. Let’s find out what the factors are that affect stock valuation or how they influence the share price.

Factors Affecting Valuation of Shares or Stock

The following are the key factors that influence the price of the stock or affect the share price valuation of a company. 

• Performance of the Company: The financial performance of the company, which includes revenue growth, operating profits, net profits and profit margins of the company in the latest financial results. If the company is performing as expected, the share price keeps moving up, while performance below expectations can affect the share price with a lower valuation.
• Industry & Sector Trend: Apart from individual performance of the company, the latest trend in the industry or sector, regulatory policies and other factors affecting the operating scope for the company also have an impact on the share price of the companies in the same sector.
• Economic Conditions: Similarly, economic factors like GDP growth of the country, central bank’s monetary policies or interest rates, inflation rates and industrial development or purchasing manager index are the key factors that also have a significant impact on the stock of all the listed companies.
• Political Factors: Political instability, government policies towards taxation and duties or changes in the administrative authorities can also affect the stock value.
• Market Sentiment: This technical factor arises due to the sentiment of the traders and investors, causing the instability or volatility in the market or the individual stock of the company.
• Demand & Supply: The high demand of a particular stock with supply constraints will push its price up, while high supply and low demand can trigger a drop in the price of the stock. Whatever the factor, to know the intrinsic valuation of a stock, you need to use the right method of share price valuation.

Methods of Stock Valuation

The right valuation method of stock helps to determine the fair price or intrinsic value of the stock. Absolute (fundamental) and relative (comparative) models are the two types of stock valuation methods followed by most of the traders or investors in the stock market.

• Absolute Valuation:This type of method is based on fundamental factors like revenue growth rate and cash flow of the company. Discounted Cash Flow (DCF) analysis and the Dividend Discount Model (DDM) are two popular methods used in the absolute valuation method.
• Relative Valuation: This type of stock valuation method is used to compare the stock with its relative peers. P/E ratio, P/S ratio, and Enterprise Value-to-EBITDA (EV/EBITDA) ratio are the common methods used to find the relative valuation of a stock to compare with other listed peers.

Different Methods of Valuation of Shares or Stocks

Let’s find out the various types of stock valuation methods in detail, to understand what parameters are considered in different methods of valuation of shares.

Dividend Discount Model Valuation

The stock price of a company is calculated on the basis of the present value of its expected future dividends paid or declared by the company. However, this method is suitable and useful for companies that regularly pay dividends, as a dividend payout history helps to assess the sustainable growth of the company.

Discounted Cash Flow (DCF)

The DCF method is used to calculate the present value of future cash flows generated by the company in the normal course of operating its business. This method considers the time value of money, in which future cash flows are discounted back to their present value, showing the prospective financial growth of the company.

Asset-Based Model

Though this method is not so popular, it can be used many times to find out the stock valuation of a company based on its assets and liabilities. This method is focused on the net asset value (assets minus liabilities) of the firm, showing its true value after paying all the obligations.

Price-to-Book (P/B) Ratio

This is another way to find out how a stock is valued in terms of total assets after paying all its liabilities. The ratios compare the market value of the company against its book value, helping investors to find out the value of a company’s assets relative to its stock price. However, this method is more useful for companies that have more tangible assets in their balance sheet.

Price-to-Earnings (P/E) Ratio

This method is one of the most widely used stock valuation methods that can give you a quick idea if a stock is overvalued or undervalued. P/E ratios compare the current market price of the company to its earnings per share. A high P/E ratio shows the stock is overvalued, and a low P/E ratio shows the stock is undervalued.

Also Read: 5 Indicators That a Stock May Be Overvalued

Enterprise Value-to-EBITDA

The EV/EBITDA Ratio is used to compare the enterprise value of a company to its earnings before interest, taxes, depreciation, and amortisation (EBITDA). This method helps to know the value of a company by comparing its total value (including debt) to its operational cash earnings, but it is more useful for cross-border comparisons. 

Why Valuation of Shares or Stocks is Needed?

The stock valuation is necessary to find out the true intrinsic value of the company, its financial position and the economic worth of the company. And this is more needed when market prices are unreliable or unavailable, or it is required for strategic or legal purposes. However, there are multiple other reasons why stock valuation is necessary that need to be discussed.

• Mergers and Acquisitions: When two companies are involved in a merger and acquisition, to determine the share swap or exchange ratio of shares, the stock valuation is done.
• Initial Public Offering (IPO): A private or unlisted company looking to become a public company and list in the market through IPO needs to find out the value of the stock of the company.
• Sale or Purchase of Company’s Stock: A private company is not listed, hence the valuation of stock is necessary at the time of sale or purchase of such a company.
• Investment Decisions: This is one of the major reasons, or you can say the prime factor applicable for all types of listed or unlisted shares to know the fair price of the company’s stock to make the right investment decision.
• Conversion of Stocks: When debentures or preference shares are converted into equity shares, the valuation of stock is necessary to calculate the share price.
• Employee Stock Option: When a company plans for employee stock option, then to fix the exercise price for employee stock options, the valuation is necessary.
• Security Against Loan: When financial institutions or banks offer a loan against shares of the company, the stock valuation is necessary.
• Taxation Purposes: At the time of calculating the capital gains tax or determining the wealth tax, or while computing gift tax to estimate the market value of the income tax assessments, stock valuation is also done.

Wrapping-up

Valuation of stock is the process of determining the fair price or intrinsic value of the share of a company. Though, the value of stock can be affected by various factors like company performance, industry or sector trend, economic conditions and level of demand or supply of shares in the market. 

And, there are different methods of stock valuation like DCF, Dividend Discount, P/E Ratio, P/B Ratio and the enterprise value to EBITDA model used as per the requirement, feasibility and availability of data. However, valuation of stock is necessary to determine the fair market price of the shares or calculate the intrinsic value to make the right decision at the time of investing in the stocks of a company.