Stock valuation is all about determining the fair price for a stock based on the health and potential of the company.
If a company is doing really well, making lots of money, and is expected to keep growing, the stock is more valuable because it’s a piece of a successful and growing business. On the other hand, if the company is struggling or facing challenges, the stock is worth less because it represents a smaller portion of a company with uncertain prospects.
Some investors use valuation to decide whether to buy, hold, or sell the stock, aiming to make informed decisions that can lead to profitable outcomes.
Stock valuation: a must for your investment process?
Is it absolutely necessary to use valuation calculations in your investment process? I don’t believe so, and here’s why:
- There are several stock valuation methods, and each method can produce different results.
- Each method requires that assumptions be made about cash flow, dividend, or earnings growth, etc.
- Each assumption is a best guess.
- Change an assumption and you get a different result.
What I dislike the most about stock valuation is that it tends to create doubt in the investors’ mind. “What if I pay too much for this company?”. “Maybe I should wait and buy when the price goes down.”. “The price went up another 10%, so am I missing a great opportunity?”. You get the picture. For this reason, stock valuation is not my criteria for buying or selling a stock.
Also, valuation has little impact for me because after analyzing a stock, an essential step in my buying process, I don’t really mind the price I pay when I purchase it.
Not so fast
Stock valuation is not completely useless. In fact, from time to time, it clearly helps to find hidden gems and make good money on them. “But Mike, you just said valuation wasn’t your criteria for buying or selling…” To be clearer, I never buy or sell based solely on stock valuation, but I still have a peek. Why? To get a better idea of what price I’m really paying when I buy shares.
Making investment decisions solely based on valuation could prevent you from buying amazing stocks while keeping your money idling on the sidelines for no good reason. However, using stock valuation tools to identify where you will get the best return is a good idea. Valuation tools can also help to identify red flags, i.e., companies that are surfing too much on hype and that could crash once the lights come on.
At DSR, we provide four different tools to help you identify hidden gems:
- P/E ratio history and forward PE
- Dividend Yield History
- Dividend Discount model (DDM)
- Refinitiv value score
We’ve established that we should not let valuation control our investment decisions, but at the same time we should not disregard it completely. I look at valuation to add more context to my analysis.
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Stock valuation methods pinpoint what to investigate
Looking at the PE ratio and dividend yield history graphs tells me a lot about how the market viewed a company over the past 5 or 10 years.
These graphs guide my investigation. Thanks to them, I easily see which year(s) or quarter(s) I should investigate to discover the reasons behind the growth or deceleration. Combining both a historical graph with the dividend triangle often reveals why a company saw its stock price continuously rise or decline.
A company showing a strong dividend triangle is likely to see its PE expand; investors are willing to pay a higher multiple of profits when they believe a company will continue growing at a fast pace. For example, the Apple (AAPL) PE ratio doubled from 14 to 28 from 2012 to 2022.
In 2012, Apple was riding each iPhone launch as its only way to generate growth. Ten years later, Apple showed a complete ecosystem of integrated products and services with several growth avenues. Both versions of the company were great; but as expectations of growth are greater now, investors pay a higher price for a piece of it.
A drop in PE could be caused by concerns about slow growth in sales, earnings, or both.
Stock valuation to compare similar companies
When I find myself hesitating between a few great companies operating in the same sector or sub-sector, looking at their Dividend Discount Model value and Refinitiv Value Score helps me identify where I can get the best bang for my buck.
Using the DDM, I compare companies that show a similar dividend growth rate in a similar situation; using the same discount rate for all companies, I can identify which one offers the best value for the future dividends likely to be received. To add more layers to my analysis, I also compare the companies’ Refinitiv Value Scores. After all, the aggregation of multiple valuation metrics is a powerful way to identify undervalued securities within seconds.
To summarize my thoughts on stock valuation I would say that while valuation tools can hardly be defined as accurate indicators of whether a stock is a bargain, a fair price, or overvalued, they are useful as an add-on to your stock analysis process to guide your investigation of a company, and compare stocks from similar companies. That is precisely how I use them.
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