Stock Valuation: How to Estimate the Value of a Stock Using Stock Valuation Techniques

For investors, it is very important to consider many different factors before buying stock in a company. But without discipline or knowledge of what you are looking for, sorting through all of the available information can be extremely challenging and time consuming.

To simplify the research process, many investors employ targeted methods to determine if a stock fits their ideal profile of a good investment.

Why would you want to do this? Let's compare this to a real life situation. Let's say you're lost in the mountains on a hiking trip, and you're thirsty and looking for a stream. How would you find the stream without a map or any further information?

You can look for several different clues, based on your knowledge of where streams are typically located in mountains. You know that streams are typically located in ravines or valleys as opposed to peaks. You also know that in mountains, waterfalls often accompany streams and often can often be audibly detected. Additionally, it is likely that there will be lush vegetation near a stream due to the abundance of water and nutrients.

You would probably agree that looking for all three of these clues will likely help you to find the stream faster than if you did not know what to look for.

Likewise, knowing how to utilize a number of clues that arise from a few targeted stock screening and valuation methods can help you more quickly find quality investment opportunities. These clues will usually provide valuable information about a company's financial health, its management, and its short and long-term competitive position.

So what are these methods, and how do you use them? Let's break it down.

Analyze Financials

Most would agree that it would be impossible to estimate the value of a stock without doing some financial analysis. A company's financials are the evidence that it has been doing the right things to create sustainable profits and/or growth. There are several ways you can analyze financials.

  1. Top Down Look at Financial Statements - Take a quick look at all three major financial statements (Balance Sheet, Income Statement, Cash Flow Statement) to determine if you want to research the company in more depth. Look for debt to asset levels, increasing profits, and positive or improving cash flows.

  2. Financial Ratio Analysis. - Learn how to use ratios to analyze a company's financial health. Use a targeted set of ratios including:

    • Return on Invested Capital (ROIC) - tells you how effectively a company is using its capital to grow its business. Good measure for management.
    • Price to Earnings Ratio (PE Ratio) - tells you how expensive a stock is relative to its earnings. Good measure for valuation.
    • Price to Earnings Growth Ratio (PEG Ratio) - tells you how a stock is priced relative to its growth. Good valuation and/or growth measurement.
    • Return on Equity - tells you how much a income is generated as a percentage of stockholders equity. Measure of management effectiveness.
    • Dividend payout ratio - the percentage of net income that is paid out as dividends. When looked at historically and in context, can tell you a number of different things about growth and profitability.
    • Balance Sheet Ratios (Debt to equity, current ratio) - can indicate the health of a company's balance sheet and ability to weather difficult economic times.

    Analyzing these and other financial ratios, especially in historical context, can help you decide if a company's financials make the grade.

  3. Intrinsic value calculation - Use a formula to predict the price of a stock at some point in the future based on your assumptions for earnings growth and PE ratio. Use this formula to determine what price to pay only after you have decided that you are interested in investing in the stock.

  4. Analyze a company's competitors using the methods above to better determine its competitive position.

To help you more easily analyze financials and calculate intrinsic value, we have developed a Free Stock Analysis Spreadsheet. Check it out today and see how it can help you more quickly analyze a stock.

Review SEC Reports

Another method of uncovering information about stock valuation is through reading SEC (Securities and Exchange Commisssion) reports.

SEC reports have a good deal of valuable information that isn't available in other places. Companies are required to disclose a lot of information in these reports, especially the quarterly and annual reports. They can help you figure out if a company is well positioned for the long run, both financially and competitively. Many investors don't go to the length of reading these reports, so if you do you can gain a leg up on them.

Analyze Industry and Competition

Skim through some articles and/or annual reports of other companies in the same industry. In light of the company's financial position, this will give you a better idea of how the company stands in its industry or sector.

Does the company you're researching have a strong balance sheet comparatively? How are its profits growing compared to its biggest competitors?

Analyze Insider Ownership

How many of the company's officers own stock and have bought stock recently? If there is a lot of insider buying, this can give you an idea that it might be a good time to buy a stock. Conversely, if insiders are selling, it may be a warning sign that the stock is about to take a dive.

In Conclusion

The best investors use a number of different stock valuation methods to uncover investment opportunities. Using consistent and targeted valuation techniques will likely yield better results than haphazard and inconsistent methods.

A big part of analyzing a stock is being able to accurately assess its financial position. With this in mind, we have developed a Stock Analysis Spreadsheet to help you simplify the process of analyzing a stock's financials. Check it out today and see how it can save you time and make financial analysis much faster and easier than before.

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