Sunday, 1 July 2012

Two Approaches to Stock Valuation

There are two broad approaches to stock valuation. One is the ratio
based approach and the other is the intrinsic value approach.

If you have ever talked about a P/E ratio, you've valued a stock using
the ratio-based approach. Valuation ratios compare the company's
market value with some financial aspect of its performance--
earnings, sales, book value, cash flow, and so on. The ratio-based
approach is the most commonly used method for valuing stocks,
because ratios are easy to calculate and readily available.

The downside is that making sense of valuation ratios requires quite
a bit of context. A P/E ratio of 15 does not mean a whole lot unless
you also know the P/E of the market as a whole, the P/Es of the
company's main competitors, the company's historical P/Es, and
similar information. A ratio that looks sky-high for one company
might seem quite reasonable for another.

The other major approach to valuation tries to estimate what a
stock should intrinsically be worth. A stock's intrinsic value is based
on projecting the company's future cash flows along with other
factors. You can compare this intrinsic or fair value with a stock's 
market price to determine whether the stock looks underpriced, fairly
 valued, or overpriced.

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