Equity Valuation? Investor’s Estimate Stock Target Price

Key Points

• Equity Valuation seems like a topic for finance nerds but it really boils down to the simple question of: How much am I willing to pay to own something?
• In the case of equities this is the price you are willing to pay to own a share of a business. Valuation in theory is the discounted value (discounted by an interest rate to account for the opportunity cost of just leaving your money in risk free bonds) of all future cash flows of a company (dividends, stock buybacks, terminal value). 
• Valuation is an art rather than a science as one’s opinion and projections are required. It is unlikely for any market participant to have the exact same value of a company as another. 
• There are multiple methods of valuation- Discounted Cash Flow, Price/Earnings, Competitor Valuation. 
• At GenVest, valuation is an important part of the process but it needs to be backed by fundamentals. 

Understanding the Concept of Equity Valuation

The term “valuation” can bring some pretty scary thoughts to your head. If you have ever taken a finance course in college there is no doubt that this concept was one that kept you up the night before a test. 

But in reality valuation is pretty simple, as at the end of the day it asks the question “How much is this worth?”. We could be valuing a product, a house, a cup of coffee or in this case the value of a publicly traded company. 

It is important to note that my valuation of a company could be different than yours and from research analysts on Wall Street. Valuation is more so an art than a science and any type of “target price” is really only the best guess and is a constantly changing idea.

The price you should be willing to pay for a stock is the value of all future cash flows that could accrue to you as a shareholder discounted back to its present value. Now let’s try to break that down.

Value of ALL Future Cash Flows Discounted Back to Present Value

The company might be paying dividends to shareholders or we can also look at earnings as profits that could technically be paid out to shareholders. These cash flows are discounted by an interest rate. 

This represents the opportunity cost and the time value of money of a dollar invested today being worth more than investing that dollar 5 years from now. Remember when Genvest wrote about how Your Dollar is Worth More Today!

Knowing this, there are a few different ways to get an idea of the value of a business. Perhaps the most in-depth is the Discounted Cash Flow(DCF) method. This effectively estimates future earnings and cash flows and applies a discount rate in order to get the value per share of a stock. 

The issue with this is the uncertainty of estimates as it is hard enough to predict a company’s performance 6 months from now, let alone 6 years.  

Equity Valuation Through Price Relative to Earnings

Another way is relative valuation. This typically looks at a valuation metric such as price divided by EPS, earnings per share, (the amount of operating profit divided by the number of shares of a company), otherwise known as P/E Ratio. 

Relative Valuation looks at the P/E ratio in comparison to competitors, the broader industry and the company historically. 

A lower ratio typically means that the company could be seen as undervalued, but it is important to remember that there could always be a reason behind that. 

Investors want to purchase stock at an attractive price but it is important to ensure the company’s fundamentals and outlook have not deteriorated to where it creates a “value trap”. This is when a company looks attractively priced but there are serious underlying issues the market sees with the company.

You will sometimes hear from experienced investors that you should take a position in a company with a lower P/E ratio than their competitors. In certain scenarios, this may hold true, but we also want to point out that a higher P/E ratio could indicate market expectations for a company to grow their earnings at a higher rate than their competitors.

If two companies are in the same industry and one has a higher P/E ratio than the other, try to conduct some research and see why the stock price has increased. No investor wants to overpay for the stock of a company but an investor should always understand Why Business Outlook is important for equity growth.  

GenVest QuickTake

Fundamental backing behind the valuation is important to consider. The numbers need to be able to tell a story and help with the process of determining if a company’s stock price is undervalued or overvalued. Ultimately we can try to put a price on these stocks but investor opinion matters as well and can be vastly different amongst community members. 

Quarterly earnings can temporarily change the stock price of a company in the short-term but it is more so investor sentiment moving it over the long-run.

The best approach is to understand what really drives the stock and what it is that investors are looking at for a particular company. It never hurts to combine different approaches to reach a decision considering equity valuation is more so art than science.

Last but not least, investors should always be weary of the herd mentality driving up prices to insane valuations. There is a point at which a stock is just too darn expensive to make sense.

Perfectly trying to time the market is never advised as well and can possibly lead to more damage over the long-run by never getting invested in the first place. 

However, patience for not always the perfect price but an attractive price of a quality company will typically yield better returns and provide a margin of safety.