How to Value Stocks: A Guide for Beginners

how to value stocks

When you are looking to invest in the stock market, it is important to understand how to value stocks. This will help you make better decisions about which stocks to buy and when to sell them. In this guide, we will walk you through the basics of how to value a stock. We will also discuss some common valuation methods that investors use. By understanding how to value a stock, you can make more informed investment decisions and maximize your profits.

What is a stock, and how does it work?

A stock is a type of security that represents ownership in a corporation. When you buy a stock, you are buying a piece of the company. You become a shareholder and have a claim on the company's assets and earnings.

You can decide to keep that claim or share ownership for any time period you'd like or sell it to someone else.

Your goal as a shareholder is to make money by seeing the value of your shares increase over time which generally happens when the business is performing well.

There are two ways to make money from owning stocks: dividends and capital gains. Dividends are payments that companies make to shareholders out of their profits. Capital gains occur when you sell your shares for more than you paid for them.

Now that you know a little bit about how stocks work, let's discuss how to value them.

Why do stocks go up and down in value, and what affects stock prices?

The price of a stock is determined by supply and demand. If more people are buying a stock than selling it, the price will go up. If more people are selling a stock than buying it, the price will go down.

Many factors can affect the supply and demand for a particular stock. Some of these factors include:

  • Earnings
  • Dividends
  • Company news
  • Analyst ratings
  • Economic conditions
  • Interest rates
  • Competitors actions

When valuing a stock, it is essential to consider all of these factors.

Furthermore, you should always remember that stock prices can be volatile and go up and down in the short-term. It is important to think about the long-term when you are making investment decisions.

This is one of the reasons valuing stocks is helpful because it helps you to assess the value of a stock despite any volatility affecting the stock price in the long-term (more on that below).

Why value stocks?

"Mr. Market is kind of a drunken psycho. Some days he gets very enthused, some days he gets very depressed. And when he gets really enthused you sell to him, and if he gets depressed, you buy from him. There's no moral taint attached to that." Warren Buffet.

There are a few reasons why you might want to value stocks. First, it can help you make investment decisions. Knowing how to value a stock can better assess whether it is undervalued or overvalued. This information can help you decide when to buy or sell shares. As Buffet mentions, the market is often volatile without reason, and that presents attractive buying and selling opportunities.

Second, valuing stocks can help you improve your investment performance. Knowing how to value stocks can calculate your expected return on investment (ROI). This will guide you to find stocks that are likely to earn you the return you desire.

Third, valuing stocks can help you create a more diversified portfolio. By understanding how to value stocks, you can choose investments that are not correlated with each other. This will help reduce risk in your portfolio.

Last, valuing stocks can help you identify potential opportunities. If you know how to value a stock, you can find companies that are undervalued by the market. These companies may be good candidates for investment.

How to value stocks?

Now that we've discussed why you should value stocks, let's discuss how to do it. There are a few different methods that investors use to value stocks.

The dividend discount model

The first method is called the dividend discount model. This model values a stock based on the present value of future dividends.

To calculate the present value of future dividends, you need to know the dividend payout ratio, the required rate of return, and the growth rate.

Dividend discount formula: P = D / (r-g)

where:

P = stock price

D = expected dividends per share

r = discount rate

g = dividend growth rate

For example, let's say a company is expected to pay $0.5 in dividends per share this year. The required rate of return is 15%. The dividend growth rate is expected to be 0%.

We can calculate the stock price using the dividend discount model formula based on this information.

P = $0.50 / (0.15-0)

P = $3.33

This means that the stock is worth $3.33 per share.

Check out this guide for more on this valuation method and how you can quickly get the data on your spreadsheet.

Earnings power value model

The second method is called the earnings power value model. This model values a stock based on its earnings power. Earnings power is determined by looking at a EBIT (earnings before interest and taxes), taxes, and WACC (weighted average cost of capital).

Earnings power value

The earnings power value model starts with the company's EBIT (earnings before interest and tax), not adjusted for one-time charges. Then, the average EBIT margins over a business cycle of at least five years are multiplied by revenues deemed sustainable to return "normalized EBIT."

The Normalized EBIT is then multiplied by (1 – average tax rate). The next step is to add back any excess depreciation.

At this point, the earnings figure is normalized. Adjustments now take place to account for unconsolidated subsidiaries, current restructuring charges, pricing power, and other material items. This adjusted earnings figure is then divided by the firm's weighted average cost of capital (WACC) to derive EPV business operations.

The final step to calculate the firm's equity value is adding "excess net assets" such as cash to EPV business operations and subtracting the value of the firm's debt.

EPV equity can then be compared to the company's current market capitalization to determine whether the stock is fairly valued, overvalued, or undervalued.

For example, let's say a company has an EBIT of $100. The average tax rate is 30%. The average EBIT margin over the past five years has been 20%. The WACC is 15%.

The earnings power value would be calculated as follows:

EPV = ($100 * (20%)) * (0.70)/.15

EPV = $373

The equity value of the firm would be:

Equity value = $373 + excess net assets – value of firm's debt

This model is a bit more complex than the dividend discount model. However, it may be more accurate in valuing a company.

To make this process easier, you can use this Excel template which automatically gets you the data you need for the calculation via Wisesheets.

Note: A Wisesheets account is required you can get one for free here.

Discounted cash flow model

The third method is called the discount cash flow model. This model values a stock based on the present value of future cash flows. To calculate the present value of future cash flows, you need to know the discount rate and the growth rate.

Discounted cash flow Excel
Example DCF calculation

Starting with the future cash flow is where you use your research on the company to make reasonable assumptions about the company's future revenues, capital expenditures, expenses, etc., to estimate the cash flow.

You do this for multiple years or as many years as you want to hold the stock.

Then, you calculate a terminal value at the end of the year you plan on selling. This can be based on a multiple (more on that below) for example, if in 5 years you estimate the case flow of a company to be $100 million and other companies in the same industry and position have a cash flow to value of 10 then the terminal value would be $100 million * 10 or 1 billion.

Once you calculate all these cash flows all you have to do is bring their value back to the present using the present value formula.

present value = Cash flow/(1+ discount rate)^year

You do this every year and take the sum that will tell you how much is the price you should pay for the company.

The last step is to divide the number by the number of outstanding shares, so you get the per-share value.

Altogether this process can be pretty tedious, which is why you can use this template which gets you the data you need and does the necessary calculations to find the intrinsic value of a stock given your assumptions.

Comparable multiple method

The fourth and final method is called the comparable multiple method. This model values a stock based on how similar companies are valued. To calculate this, you need to find the multiple you want to use, such as P/E, Price to sales, price to book, price to cash flow, etc., for a group of companies in the same industry. Then you can use the median and multiply this number by the subject company's EBIT.

Comparable multiple method Excel

Using Wisesheets, you can see these ratios very quickly across these companies in the same industry.

As you can see, based on the median, you can find the intrinsic value of apple using the various multiples to get a better sense of the value.

Which valuation method is best?

There is no right or wrong answer when it comes to choosing a valuation method. It ultimately depends on your investment goals and objectives.

If you are looking for a long-term investment, the dividend discount model or the earnings power value model may be a good option for you. On the other hand, if you are looking for a short-term investment, the discount cash flow model may be a better option.

No matter which method you choose, it is important to do your own research and make sure that you are comfortable with the assumptions that you are making.

Now that you know how to value stocks, you can start making more informed investment decisions. Remember to consider all the factors and always do your research before making any decisions.

How can you tell if a company is worth investing in, and what factors to consider when making your decision?

When you are trying to determine if a company is worth investing in, there are a few things that you should consider. First, look at the company's financial statements. This will give you an idea of the company's revenue, expenses, and profit.

Check out this guide we have created on the topic.

Next, research the company's management team. It is important to invest in companies that have a good management team in place. The management team is critical because they are the ones who are responsible for the company executing well, which in turn leads to appreciation in the stock price.

Finally, look at the company's competitive landscape. You want to invest in companies with a competitive advantage over their rivals. The stronger the advantage/s, the more likely the company will still operate successfully over time and generate positive returns for shareholders.

These are just a few of the things that you should consider when making your investment decision. By considering all of these factors, you can make more informed decisions about which stocks to buy and when to sell them.

What are some signs that a stock is overvalued or undervalued?

There are a few different indicators that a stock might be overvalued or undervalued.

One indicator is the price-to-earnings ratio (P/E ratio). This ratio measures how much investors are willing to pay for each dollar of a company's earnings. A high P/E ratio could be a sign that a stock is overvalued.

Another indicator is the price-to-book ratio (P/B ratio). This ratio measures how much investors are willing to pay for each dollar of a company's book value. A low P/B ratio could be a sign that a stock is undervalued.

Finally, you can compare the market value of a company to its intrinsic value. The market value is what investors are currently willing to pay for the stock. The intrinsic value is what the stock is actually worth (you can find the company's intrinsic value using the methods above). If the market value is significantly higher than the intrinsic value, it could be a sign that the stock is overvalued.

When analyzing a stock, it is important to look at multiple indicators. This will give you a more complete picture of whether or not the stock is overvalued or undervalued.

What are some common mistakes people make when investing in stocks, and how can you avoid them?

Some common mistakes people make when investing in stocks are:

  • Not diversifying their portfolio
  • Not understanding how to value stocks
  • Investing based on emotions

To avoid these mistakes, it is important to educate yourself about the stock market and how to value stocks. You should also create a diversified portfolio that includes a variety of different types of stocks. By following these tips, you can minimize your risk and maximize your chances of success.

How much should you invest in stocks, and how often should you check their value?

This is a difficult question to answer, as it depends on your individual circumstances. However, there are a few general guidelines that you can follow.

First, you should only invest money that you can afford to lose. This means you should not invest money you need for daily living expenses or emergency savings.

Second, you should create a diversified portfolio. This means investing in a variety of different stocks, bonds, and other assets to maximize your risk-adjusted return.

Third, you should check on the value of your investments periodically. This could be monthly, quarterly, or yearly. Checking too often can lead to anxiety, as stock prices can fluctuate day-to-day.

By following these guidelines, you can ensure that you are investing in a way that is right for you. Remember to always do your own research and consult with a financial advisor if you have any questions.

Conclusion

Now that you know how to value stocks, you can start making more informed investment decisions. Remember to consider all the factors and always do your research before making any decisions.

Happy investing!

Let us know if you have any questions below 👇

Guillermo Valles
 | Website

Hello! I'm a finance enthusiast who fell in love with the world of finance at 15, devouring Warren Buffet's books and streaming Berkshire Hathaway meetings like a true fan.

I started my career in the industry at one of Canada's largest REITs, where I honed my skills analyzing and facilitating over a billion dollars in commercial real estate deals.

My passion led me to the stock market, but I quickly found myself spending more time gathering data than analyzing companies.

That's when my team and I created Wisesheets, a tool designed to automate the stock data gathering process, with the ultimate goal of helping anyone quickly find good investment opportunities.

Today, I juggle improving Wisesheets and tending to my stock portfolio, which I like to think of as a garden of assets and dividends. My journey from a finance-loving teenager to a tech entrepreneur has been a thrilling ride, full of surprises and lessons.

I'm excited for what's next and look forward to sharing my passion for finance and investing with others!

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