Have you ever watched the news and listened to analysts talk about a company and think to yourself: How do they know all that? Well it’s their job to know, and if the company is publicly traded in the stock exchanges then they are required by law to disclose their financial statements every quarter (3 months). This article will aim to simplify some methods that analysts use to value a company. Keep in mind that the best way to learn this is to try it out (it’s free) and it can help lead you towards financial freedom!
The definition of value is the monetary worth of something. A family vase has much more value to the family than an outsider. In the market, supply can also raise or lower the value of something based on the demand. If a company builds only 10 cars of the same model it would be valued at a much higher price as if they build 1 million. In other words, value of stocks is in the eye of the beholder.
I will explain 3 ways a company’s valuation is done. Please don’t be intimidated with the language. If you don’t know a term, just go on Investopedia and you will find the answer right away with a thorough example. These valuations may sound similar, but they’re not.
Here is the outline:
1) Asset Methods
2) Free Cash Methods
3) Comparable Methods
1) The Asset method:
This is what is called “book value.” In very simplified terms, book value is the cost of the company if it were to be sold tomorrow and all the creditors were paid off. It includes things such as: cash, current assets, working capital, shareholder’s equity, brand-name and goodwill.
These can be found in the Balance Sheet of the company. In order to get ahold of the balance sheet, you go to the publicly traded company’s website and under the “Investors” section you look for “Balance Sheet”. You have to go and find the values of how much cash the company has, how much is equity capital, how much money employees and management are paid etc… Then subtract it by the debt of the company and you should come up with an estimate.
The next step is to compare your estimate (or the value you have decided the company is) by the number of outstanding shares plus the long term debt (Market Cap).
- If it is the same price as if you were to sell the company tomorrow and pay off all the debtors (assets), then the company is fairly valued.
- If the company’s Market cap is higher than the assets, than the company is overvalued.
- If the company’s Market cap is lower than the assets, than the company is undervalued.
Using this technique you can decide on whether to invest in the company by buying its stock.
2) Free Cash Method:
This method is used mostly by investment bankers. Many investors are completely ignorant of a company’s cash-flow, but it is an important indicator of the company’s current standing. After taking out all of the fixed expenses cash-flow is literally the cash that flows through the company during the course of the quarter or year.
It is normally defined as (EBITDA) Earnings Before Interest, Taxes, Depreciation and Amortization. This is important because cash-flow is designed to focus on the operating business not the costs of running the business or profits. Taxes can change given by who’s in charge of the political realm and this can fluctuate the earnings of a company.
For example, if taxes are set to double in a given year, an investor or analyst would use EBIT – Earnings Before Interest and Taxes. This would be a good way to evaluate the company’s growth instead of using any other way to evaluate the company. If another way was used (i.e. earnings, sales etc…) they would mast the company’s real operating situation.
Depreciation and Amortization are non-cash charges but if you’re valuing the company for the long term it may mask the cash strength. These are accounting principles and can be founded on a company’s Income Statement.
3) Comparable Methods
This is the most common way to value a company. This method uses the earnings of a company. Earnings are also called net income and it is the money that is left over after the company pays off all its bills. Most people use the earnings per share (EPS) in order to compare the company’s earnings with the amounts of shares the company sells in the public market.
Using this, you will also come across what is known as a “trailing EPS.” This just means that the calculations look at the previous 4 quarters. If the current EPS is similar to the trailing EPS, it means that the company has consistent earnings throughout the year.
There is also Price to Earnings ratio (P/E ratio) which is used to measure the current stock price with the company’s earnings. This ratio takes the stock price and divides it by the last four quarter’s worth of earnings (Trailing EPS).
WARNING: There are many individual investors that stop their analysis here. They use the P/E ratio as the Holy Grail. They read Benjamin Graham’s book “The Intelligent Investor” and believe his formula of valuing a stock is the key to success. But what the newer versions of the book don’t disclose is that in the 1970s there was one VERY IMPORTANT FOOTNOTE that was removed from the original book. That footnote stated: “Note that we do not suggest that this formula gives the ‘true value’ of a growth stock, but only that it approximates the results of the more elaborated calculation in vogue.” If you have the original book check pg.158, Footnote 7.
There is also the Price-to-Sales ratio (PSR). Every time a company sells a customer something, it generates revenues. Keep in mind that earnings and revenues are not the same thing. A company can still generate revenue even if they doesn’t make money. This ratio will just compare the stock price to the revenues of the company.
You can use these comparable to value whether a company is fairly valued, undervalued or overvalued.