What is a stock’s true value? This question has challenged
equity investors and analysts since stocks were first traded. At the core of
any buy or sell recommendation lies some estimate of the stock’s intrinsic value
— what it should be worth. But analysts
calculate this value many different ways, employing different methodologies and
taking into consideration a multitude of different qualitative and quantitative
factors that can result in wide disparities.
While there is no “right” way to value a stock, certain
valuation techniques can be more valid in some cases. A growth-oriented
investor, for instance, may place greater weight on a company’s earnings growth
potential, while a value-oriented investor may place greater emphasis on a
stock’s valuation relative to its peers.
Three of the most widely used approaches to security
valuation are net present value, the dividend discount model, and multiplier
analysis. We’ll focus on multiplier analysis because it is the most widely
Looking at a stock’s price as a multiple of its earnings, revenues
or assets is the most commonly used valuation metric among analysts and
investors. Analysts will typically scrutinize the results of these ratios to
examine how investors are currently pricing a publicly-traded company, noting
how these multiples compare to industry peers, benchmark indices and market
ratio, or P/E, is by far the most widely used valuation metric. It
indicates how much investors are currently willing to pay for each dollar
of the company’s recent, current or estimated earnings.
- The price-to-sales ratio
(P/S) indicates how much the market is willing to pay for each dollar of
sales. It is derived by dividing a company’s total market value (stock price
times number of shares outstanding) by its yearly revenues. Investors will
often use this approach when companies have not recorded a profit. The
logic is that if sales are strong and growing, and the company is otherwise
healthy, earnings may be just around the corner. Value investors, on the
other hand, look for low price to sales ratios for stocks for companies
that may have been unwittingly thrown on the scrap heap.
ratio (P/B) is the result of dividing market capitalization by book value,
also known as shareholder equity. Book value represents the company’s
theoretical liquidation value, if the company shut down operations, paid
off its debts and sold off its assets. As such, the usefulness of book
value as a valuation tool depends significantly on the industry. It is
particularly relevant in capital intensive businesses.
Use the Entire Tool Kit
In practice, investors will consider several different valuation
approaches and then look at a variety of other information before arriving at a
final value. They will try to determine whether a company is fundamentally
sound by scouring public reports (10-Ks, 10-Qs, Annual Reports) examining industry
trends and understanding the regulatory and market environments, among many
other things. They will also consider technical factors such as the stock’s
trading history and trends. Ultimately, the “final” valuation will consider a
multitude of factors, which may vary widely from analyst to analyst, and is
ultimately up to the market’s judgement.
Company Valuation Analysis
Analysts use multiple criteria for valuing a company,
Intrinsic Value Analysis
- Determines the security’s
“intrinsic value” based on discounted “free” cash flow (DCF) analysis.
future “free” cash flows that are discounted back to current dollars,
including variables such as risk assessment and capital structure.
shares vs. current share price.
DCF to make it more reasonable (e.g. interest rate inputs)
- Assesses a security’s
relative value by comparing appropriate financial ratios across peer
groups and industry group.
metrics, including P/E trading history, high/low in cycle and current P/E
Sum of Parts
value” of a stock by determining private market values for a firm’s
stand-alone business units.
value for each division.
No matter what your investment goals may be, a systematic
process for stock selection can help take the emotions of your decision making.
With that in mind, let me assist you in developing a process that will help
determine which stocks to buy or sell and how to manage your overall portfolio.
If you’d like to learn more, please contact Phil Zaczek 312-419-3629 Phil.zaczek@MS.com.
Securities’ prices may fluctuate in response to specific situations for each
company, industry, market conditions, and general economic environment.
Growth investing does not guarantee a profit or eliminate risk. The stocks of these companies can have relatively high valuations. Because of these high valuations, an investment in a growth stock can be more risky than an investment in a company with more modest growth expectations.
Companies paying dividends can reduce or cut payouts at any time.
Article by McGraw Hill and
provided courtesy of Morgan Stanley Smith Barney Financial Advisor.
The author(s) are not
employees of Morgan Stanley Smith Barney LLC ("MSSB"). The opinions
expressed by the authors are solely their own and do not necessarily reflect
those of MSSB. The information and data
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and MSSB makes no representations or guarantees as to the accuracy or
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information provided nor any opinion expressed constitutes a solicitation by
MSSB with respect to the purchase or sale of any security, investment, strategy
or product that may be mentioned.
Smith Barney Financial Advisor(s) engaged New Lenox Patch to feature this article.
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