3 Popular Stock Valuation Methods Used On Wall Street
Professional investors use several valuation methods to determine whether a company is overvalued or undervalued. There is no “one way” to value a company. Some methods work better for certain companies than others.
Let’s go over the 3 popular valuation methods professional investors on Wall Street use to analyze company valuations.
The 3 Popular Valuation Methods:
DFC (Discounted Cash Flow) Valuation
Book Value/Liquidation Value
Comparable Company Analysis
DCF (Discounted Cash Flow) Valuation
The DCF valuation method attempts to determine the value of an investment today based on how much money that specific investment might generate in the future.
The idea behind the DCF method is that free cash flow (the money left over after paying all expenses and company investments) is what drives value for investors. That is because free cash flow can increase shareholder value through dividends or stock buybacks in the future.
Which is why many professional investors like the DCF analysis method. It attempts to value a company today based on how much free cash flow a specific investment may produce in the future.
The Steps To Calculate DCF
Step 1: Forecast the expected cash flows from the investment you are analyzing.
This is when you estimate how much free cash flow a specific investment might generate. This is usually done over the next 5 years.
The longer you attempt to estimate free cash flow, the less reliable the projection becomes due to the future being uncertain.
Step 2: Determine a discount rate.
The word “discount” here means “to deduct an amount.” A discount rate is used to deduct the future value of money to come up with its present-day value.
For example: $1,000 invested today in a fund that offers a 10% annual interest rate will grow to $1,100 one year from now. In other words, $1,100 (future value) when discounted by the rate of 10% (discount rate) is worth $1,000 (present value) as of today.
Many investors use a company's Weighted Average Cost of Capital (WACC) as the discount rate, which is simply the average rate a company expects to pay to finance its assets.
Step 3: Discount the forecasted cash flows back to the present day.
You can do this using a DCF calculator, excel, or manually with a calculator.
The Disadvantages To DCF Analysis
Investors must estimate a discount rate and cash flows correctly. Failing to do so will give you an unreliable projection.
Book Value/Liquidation Value
The book/liquidation value is the amount of cash a business would receive if all of its assets were sold off and debts were paid off.
This method does not consider how much profit a company can generate. It simply looks at how much money a company could generate if all of its assets were sold off and its debts were paid.
The logic behind this method is that even if everything went downhill and nothing could be done to save the company, investors could always fall back on the liquidation value to recoup their investment.
Book Value Calculation
Image Source: Speck
Book Value = The amount of money you could get from selling all of the company’s assets today - the amount the company owes in debt.
The Disadvantages To Book Value/Liquidation Value
This method doesn’t consider the profit-generating business behind all its assets and liabilities. It only looks at how much money would be left over if everything was sold off.
Comparable Company Analysis
This method aims to find companies similar to the one you are analyzing. The more similar the company, the better. Once you find a similar company, you then compare and see how each company trades relative to valuation multiples such as P/E (price-to-earnings ratio) or EBITDA (Earnings before interest, taxes, depreciation, and amortization).
The logic behind this method is that similar companies should be trading at similar valuation multiples.
For example: If a company that is nearly identical to another company is trading at a lower P/E ratio, that could indicate the company is undervalued.
The Steps To Run A Comparable Company Analysis
Step 1: Find the right comparable companies.
This has to be a company similar to the company you are analyzing. Similar company size, growth rate, industry, and profit margins. The more similar the company is, the more accurate your analysis will be.
Step 2: Gather valuation multiples.
Once you’ve created a list of similar companies, it’s time to gather all of the financial data. You will want to look at metrics like P/E, EBITDA, and EPS for mature businesses. For earlier-stage companies, you may look at P/S (price-to-sales ratio), Gross Revenue, or Gross Profit.
Step 3: Compare valuation multiples.
Compare all of the valuation multiples and make notes of the companies that are trading at different multiples, despite the similarity in companies.
If a company that is nearly identical to another company is trading at a lower P/E ratio, that could be an indicator that the company is undervalued.
The Disadvantages Of Comparable Company Analysis
It is challenging to identify comparable companies since no two companies are identical. Non-fundamental factors can also influence valuation multiples.
Final Thoughts: 3 Popular Stock Valuation Methods
Keep in mind that investors use several different valuation methods to value companies. As mentioned earlier, there is no “one way” to value a company. Some methods work better than others, depending on the company you are analyzing.
Some investors use a mixture of different valuation methods, while others use one.
If there was a simple valuation method that worked every time, everyone would use it, and finding undervalued companies would be easy.
20 Stock Research Questions
Your most significant advantage will be researching companies you deeply understand. Perhaps a company you work for. Or an industry that you have a lot of experience in.
The bonus research questions below are meant to guide you in the right direction when doing your homework on a specific company.
This isn’t the “end all be all” research question framework. These questions are meant to move your research in the right direction.
Part 1: General Company Questions
What is the company’s mission/value?
What problem does the company *actually* solve?
What does this company do very well at?
What does this company struggle with?
What are the company's potential opportunities?
What are the company’s potential threats?
Part 2: Financial Questions
How does the company make money?
How does their revenue growth look?
Is the company currently profitable? If not, why and when?
How might this company perform during a recession?
How does their overall financial situation look?
Can they raise prices without customers switching to a competitor?
Part 3: Leadership Questions
Are the CEO and executive team the right people for the job?
What is the executive team’s track record?
How have they handled pressure in the past?
What type of culture has the leadership created?
What does the stock “Insider Ownership” look like?
Part 4: Competition Questions
Who are the company’s biggest competitors?
How does this company differ from its competitors?
How powerful is the company’s brand?
How loyal are the company’s customers to their core product?
How does the company’s overall industry look?
Best Stock Research Websites:
SEC.gov (EDGAR) You can pull up all of the company’s financial filings using the SEC’s website. Form 10-k, Form 10-q, Form 8-k, etc can all be found here.
Seekingalpha.com Seeking Alpha is a great tool to find independent stock research from different analysts and investors. You can find different perspectives on stocks from yours that can help challenge your investment thesis before you pull the trigger on an investment.
finance.yahoo.com (Yahoo Finance) Yahoo Finance belongs to the best free investment sites that empower investors to research companies and monitor breaking stock news.
Finviz.com Finviz is a great free stock research tool. Finviz provides a fantastic user interface to observe fundamental data on the companies you are researching.
Wsj.com The Wall Street Journal is full of insightful business articles and economic news.
Also, sign up for my email list to be the first to know when I publish a new blog post!
Want to keep learning? Check out some of my other blog posts:
As Always: Buy things that pay you to own them.
-Josh
Blog Post: #039
