An introduction to stock valuations

How to be better informed about your stock market investment decisions

approach and look at the company’s expected future cash flows. Today, we will consider four methods of stock valuations: the price-to-earnings ratio, the price to book ratio, the dividend discount model (DDM), and the discounted cash flow model (DCF). We can’t say for certain which method is the best but a combination of these methods are a good starting point to determine the value of a stock.

Price-to-Earnings (P/E) Ratio

This is the most commonly used valuation metric and is calculated as the market price of the stock divided by its earnings per share (EPS). It gives investors an idea of how much they’re paying for each rupee of the company’s earnings. A P/E ratio below 1 suggests that the stock is undervalued while a value above 1 means that the stock is overvalued.

Company stocks usually trade near or above their EPS so the P/E ratio is usually above 1. Let’s take an example of a stock from the Pakistan Stock Exchange (PSX) to better understand this.

Consider the stock of Pakistan State Oil Company Limited (PSO). Currently it has an EPS of Rs 160 while its stock price is around Rs 133. Simply dividing the stock price by the EPS gives us the P/E ratio of Rs 0.83. This means that the stock is undervalued by at least 17% relative to its earnings. The P/E ratio of PSO suggests that an investor looking to make a profit on this stock should buy PSO. However, P/E is only one such factor of stock valuations and it is usually a mistake to base your investment decision on a single point. Which is why let us move to another method.

Price-to-Book (P/B) Ratio

This metric is calculated as the stock price divided by the book value per share. It gives investors an idea of how much they’re paying for each rupee of the company’s assets.

The book value of a stock, also known as the net asset value or shareholder’s equity, is a measure of a company’s net assets. It represents the amount that would be left over for shareholders if the company were to liquidate all of its assets and pay off all of its liabilities.

The book value of a stock is calculated by subtracting total liabilities from total assets. The formula for book value per share is: Book Value per Share = (Total Shareholders’ Equity - Preferred Stock Dividends) / Number of Outstanding Common Shares

It’s important to note that the book value of a stock is not always an accurate representation of its true value. The reason for this is that the book value only takes into account a company’s historical costs, not its current market value. For example, a company’s assets may have appreciated significantly in value, but their book value will still reflect their original cost.

In addition, some assets, such as goodwill, may not have a corresponding book value, but still contribute to a company’s overall value. Conversely, some assets may be recorded at a higher value on a company’s balance sheet than their market value, leading to an overestimation of the company’s book value.

For these reasons, the book value is often seen as a useful but limited tool for stock valuation. It’s important to consider other factors, such as a company’s earnings, revenue growth, and market conditions, when evaluating the true value of a stock.

Continuing with our example of PSO, the total shareholders’ equity according to the latest quarterly report ended September 30th 2022 is Rs 227,343.289 million, which when divided by the total outstanding shares of 469,473,300 give us approximately a book value of Rs 484. Given that the current market price of PSO’s stock is Rs 133 and its book value is Rs 484, we can say that the stock is undervalued by over 73% according to its book value.

However, a word of caution, the book value should be judged with suspicion unless otherwise indicated. So many stocks on the PSX are traded at ridiculously high or low P/B ratios, which means that in many cases, the market forces of supply and demand do not agree with the underlying book value of the stock. It might be helpful to look at the P/B ratio of a stock historically to get a better idea of how close the stock price is to the book value of the stock.

In the case of POL, investors should also look at the details of the net assets held by the firm to get a better idea whether the book values of the assets are being fairly reported. Nevertheless, sometimes a company’s share does trade far above or below its book value.

Dividend Discount Model (DDM)

This model values a stock based on the present value of its expected future dividends. Dividends are basically income that you get from owning a stock which companies can pay every quarter to once a year.

The Dividend Discount Model (DDM) is a method for valuing a stock based on the present value of its expected future dividends. It assumes that the stock’s value is equal to the sum of its expected future dividends, discounted back to their present value.

Here is how the DDM is calculated, step by step:

1. Determine the expected future dividends: This involves forecasting the dividends that the company is expected to pay out in the future.

2. Determine the discount rate: The discount rate represents the opportunity cost of investing in the stock, taking into account factors such as inflation and the risk associated with the investment.

3. Calculate the present value of the expected future dividends: This involves discounting each expected future dividend back to its present value using the discount rate. The formula for this is: Present Value = Future Dividend / (1 + Discount Rate)^n where n is the number of years into the future that the dividend is expected to be paid.

Sum the present values of all expected future dividends: The sum of the present values of all expected future dividends represents the stock’s current value according to the DDM.

It’s important to note that the DDM is a simplified model and that many factors can affect a stock’s actual value. For example, the model assumes that dividends will continue to be paid at the same rate into the future, which may not be the case. Additionally, the model does not take into account changes in the company’s financial condition or the growth potential of its business.

For these reasons, the DDM is often used as a starting point for stock valuation, but it’s important to consider other factors and use additional methods of valuation to get a more complete picture of a stock’s true value.

Discounted Cash Flow (DCF) Model

This model is similar to the DDM in that it values a stock based on the present value of its expected future cash flows. The basic idea is that the stock’s value is equal to the sum of its expected future cash flows, discounted back to their present value. The step by step process of making a DCF model is as follows:

1. Forecast future cash flows: This involves projecting the cash flows that the company is expected to generate in the future, taking into account factors such as revenue growth, operating expenses, and capital expenditures.

2. Determine the discount rate: The discount rate represents the opportunity cost of investing in the stock, taking into account factors such as inflation and the risk associated with the investment.

3. Calculate the present value of the expected future cash flows: This involves discounting each expected future cash flow back to its present value using the discount rate. The formula for this is:

Present Value = Future Cash Flow / (1 + Discount Rate)^n where n is the number of years into the future that the cash flow is expected to occur. The formulas for both the DDM and DCF models are basically the same except that one uses future dividend while the other uses future cash flow Sum the present values of all expected future cash flows: The sum of the present values of all expected future cash flows represents the stock’s current value according to the DCF model.

It’s important to note that the DCF model is a complex and time-intensive method of valuation, and it requires a high degree of accuracy in the forecasted cash flows and discount rate. Additionally, the model may not always reflect the market’s perception of a company’s value, which can be influenced by a wide range of factors, including the company’s financial condition, growth potential, and overall market conditions.

These are some of the most widely used stock valuation methods, but there are others as well. It’s important to remember that no single valuation method is perfect and that a combination of methods is often used to get a more accurate picture of a stock’s true value.

Bonus tips about stock picking from Warren Buffett

Warren Buffett, widely considered one of the greatest investors of all time, has a well-known and successful approach to stock market valuations. His approach is based on a long-term investment philosophy that focuses on finding undervalued companies with strong growth potential and a durable competitive advantage.

Here are some key elements of Buffett’s approach to stock valuations:

1. Focus on intrinsic value: Buffett believes that the value of a stock should be based on the underlying value of the company, rather than on short-term market trends or speculation. He calculates the intrinsic value of a stock by looking at the company’s financials, including its earnings, revenue growth, and balance sheet.

2. Look for companies with a durable competitive advantage: Buffett looks for companies that have a sustainable competitive advantage, such as a strong brand, a loyal customer base, or a valuable intellectual property portfolio. These companies are more likely to perform well over the long term, even if the market experiences short-term fluctuations.

3. Consider the quality of management: Buffett places a great deal of importance on the quality of a company’s management team, and he looks for managers who are honest, competent, and focused on long-term value creation.

4. Avoid overpaying: Despite his focus on long-term investments, Buffett is very mindful of the price he pays for a stock. He will not buy a stock that he believes is overvalued, even if he thinks the company has a strong growth potential.

5. Focus on simplicity: Buffett has a preference for simple and straightforward investments, such as well-established companies with a clear and understandable business model. He believes that these types of investments are less likely to be impacted by market volatility and are easier to understand and evaluate.

These are some of the key elements of Buffett’s approach to stock market valuations. While his approach is not the only way to value stocks, it has proven to be extremely successful over the years, and many investors look to him as a role model for long-term investing success. n