Equity Valuation..The Guesstimate Target Price

Understanding the Concept of 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 will pay dividends to shareholders; we can also look at earnings as profits that could technically be paid out to shareholders

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.  

Value Through Price Relative to Earnings

Another way is relative valuation. This typically looks at a valuation metric such as price divided 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. 

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 Take

Fundamental backing behind the valuation is important to consider. The numbers need to be able to tell a story. Ultimately we can try to put a price on these stocks but investor opinion matters as changes in earnings can change the stock price of a company but it is more so investor sentiment moving the market. 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.