Introduction
Valuing a stock is difficult, but it is an essential part of the stock-picking process. If investors want to find a mismatch between the company's current stock price and future cash flows, they have to know what this company is worth.
There are many valuation methods or shorthands in the form of multiples which investors can use to conclude whether the price presents an opportunity. Each provides different insights and has distinct strengths and drawbacks. In this article, we will take you through the most popular stock valuation methods and highlight what each can and cannot do.
Price-to-Earnings (P/E)
A popular valuation metric is the P/E ratio, which divides the stock price by earnings per share. The two key strengths of the ratio are that:
- it is very simple to understand; and
- it can serve as a proxy for future cash flows.
It is important to stress that a study has found that when there is a divergence between earnings and cash flow (for example, when earnings go down due to higher expenses but cash flow goes up due to lower taxes), the stock price follows the cash flow. In other words, cash flow, not earnings, is the dominant force that determines stock return over the long term. When it comes to the main drawbacks of the P/E ratio, these include the following:
- the ratio does not include risk;
- it excludes the capital needs of the business;
- it does not incorporate the time value of money (i.e. the concept that a sum of money is worth more now than the same sum of money in the future).
Price-to-Book (P/B)
Another popular metric investors use is the Price-to-Book (P/B) ratio. It is used to compare a company’s book value to its current market price. Book value is an accounting term that equals the company’s total tangible assets minus total liabilities. There are two ways to calculate the ratio:
- to divide the company’s market capitalization by the company’s total book value from its balance sheet; or
- to divide the company’s current share price by the book value per share.
The upside of the ratio is that:
- it is a simple measure;
- it indicates a margin of safety;
- it is a good indicator of value creation (for example, if a stock trades below its book value, it is almost certain that it has not earned the cost of capital in the recent past).
The downside of the measure is that:
- the ratio can be manipulated through accounting tricks; and
- it does not take into account key issues pertaining to value such as write-offs, share buybacks, and acquisitions, rendering it unreliable.
EV/EBITDA
EV/EBITDA multiple is another popular metric that investors use to value a business. The formula used here is dividing enterprise value (EV) by earnings before interest, taxes, depreciation, and amortization (EBITDA). A survey found that the P/E ratio and EV/EBITDA are the two multiples investors use most frequently. EV/EBITDA is relatively new in comparison to the P/E ratio.
The positive aspects of this measure are that:
- it is a broad measure of cash flow and the economics of a business;
- unlike P/E, it is also relevant for companies that lose money, as EBITDA is often positive even when earnings are not;
- it is relevant for companies that seek to minimize taxes by adding debt and for analyzing mergers and acquisitions.
In contrast, critics cite the following deficiencies of the metric:
- it does not take into account the capital intensity of the business to a sufficient degree;
- it does not reflect business risk, understood from the standpoint of operating leverage.
Dividend Discount Model
The next valuation technique is the dividend discount model (DDM) which values stocks by discounting future dividends. It was formalized in 1938 by John Burr Williams, a Harvard professor. The model is a quantitative method for predicting the price of a company’s stock. It is based on the assumption that the present-day price is worth the sum of all of its future dividend payments discounted back to their present value.
The upside of this measure is that:
- it accounts for the time value of money;
- it reflects the capital needs of a company; and
- it captures the company’s product life cycles.
There are some drawbacks, however. These include the following:
- the discount rate fluctuates over time;
- some companies don’t pay dividends which requires investors to create the inputs synthetically;
- the measure is cumbersome to calculate.
To conclude, P/E, P/B, EV/EBITDA, and DDM are popular valuation techniques providing distinct insights into the financial health of a company. Investors need to be aware of what each of these can and can’t do to use them effectively.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.