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What’s It Worth: How Stock are Valued

What is a stock’s true value? This question has challenged equity investors and analysts since stocks were first traded.

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
used.

Multiple Ways

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
levels.

The price-to-earnings
     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.

  • The price-to-book value
         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,
    including:

    Intrinsic Value Analysis

    • Determines the security’s
           “intrinsic value” based on discounted “free” cash flow (DCF) analysis.

  • Includes estimates of
         future “free” cash flows that are discounted back to current dollars,
         including variables such as risk assessment and capital structure.

  • Looks at present value of
         shares vs. current share price.

  • Considers 10-15 year
         projection.

  • Defines parameters around
         DCF to make it more reasonable (e.g. interest rate inputs)

  • Relative Valuation

    • Assesses a security’s
           relative value by comparing appropriate financial ratios across peer
           groups and industry group.

  • Reviews company value
         metrics, including P/E trading history, high/low in cycle and current P/E
         level justification.

  • Compares valuation vs.
         appropriate index.

  • Sum of Parts
  • Attempts to quantify “fair
         value” of a stock by determining private market values for a firm’s
         individual units.

  • Breaks divisions up as
         stand-alone business units.

  • Calculates a relative
         value for each division.

  • Arrives at a blended
         valuation.

  • Risk Assessment
  • Examines technical risk,  which involves analysis of market trends and patterns rather than an exclusive focus on company fundamentals.

  • Evaluates insider buying, which may indicate whether company executives or employees believe their stock is undervalued.

  • Quantifies “beta,” a measure of the volatility of a stock’s price relative to the general market.

  • 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

    Equity
    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
    in the article or publication has been obtained from sources outside of MSSB
    and MSSB makes no representations or guarantees as to the accuracy or
    completeness of information or data from sources outside of MSSB. Neither the
    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.



     



    Morgan Stanley
    Smith Barney Financial Advisor(s) engaged New Lenox Patch to feature this article.



     



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    Cynthia Bergier February 13, 2013 at 09:52 PM
    Pump & dump. Buy the rumor, sell the news. The whole market is propped-up by QE3 and other fancy tricks. Don't be the last-one out !

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