Fundamental Components of Stock Valuation 

Fundamental Components of Stock Valuation 

Eager to take your first step into investment in your favourite stocks but can’t make sense of their valuations? Do you feel hopelessly out of touch with the world of finance but can’t help feeling anxious about losing out on the potential of stock investment? Well, it’s your lucky day as this article is specifically for those who are itching to take the plunge but wouldn’t mind a few explanations coming their way, and in a language they can understand. It will serve to give you that boost you need to go on and be able to understand all the investment advice on the internet and elsewhere, and ultimately, make better financial decisions. 

This is not to say that valuation of stocks is in any way shape or form, a simple deal. It involves sifting through a lot of information to isolate the helpful data from the immaterial clamour. Moreover, a finance expert ought to know about the most widely recognized stock valuation systems and the settings in which they are utilized, so as to determine what stocks are worth.  

However, this is where we acknowledge the shortcomings for most people reading this post are. Knowledge of basic concepts like how to read financial statements of a company, such as income statements to understand profit margins, cash flow statements, and balance sheets to gauge the position of a company at any point in time are helpful in this regard, but may not be every person’s cup of tea. However, we’ll cut through all the theory to bring you 4 aspects that are undeniably the most vital in evaluating a stock’s worth – with the aid of the least amount of finance jargon possible. 

Before we dive into what those four factors are, we must be aware of a couple of terminologies which will help us not have to revisit them each time we come to a new concept. These are: 

1. Book Value: A company’s book value is the sum value of all of its assets minus intangible assets and liabilities. In simple terms, it refers to everything that the company owns minus those assets that aren’t material or have a known value, i.e. goodwill, brand trademark, etc., and, what the company owes. It basically means what the company has that can have value attached to it. 

2. Outstanding Shares: The amount of stocks that are owned by all of its shareholders and investors. This number can be variable at different points in time, so what number is considered for calculating with this metric needs to be taken into account. Publicly traded companies are required to make the number known to the public and it should not be that had to find. 

So without any further introductions, let us bring to you what we are talking about. 

1. Price to Book Ratio: 

The first important factor to consider here is the ratio of the company’s stock price and the book value per stock. This can be calculated by dividing the market value of the stock, let’s call it P, which is readily available on most stock trading websites and platforms, by the value obtained by dividing the book value by the total number of outstanding shares. 

The book value can be found by going through a company’s balance sheet, which can also be dug up relatively easily on the internet. It is usually present in the company website within their financial information that has been made public. The amount of outstanding shares may also be found here. Dividing the former with the latter gives us the value, say B, which can be the denominator in the ratio we are talking about. 

Hence, the Price-to-Book ratio = P/B, where  

P = the market price of each share, and B = book value/number of outstanding shares 

How this ratio is helpful: 

A high Price-to-Book ratio means that a company’s stock is likely overvalued and in the same way, that which is low could mean the stock is undervalued. Should you be able to calculate this ratio for a number of companies in a given sector or industry, comparing these values as opposed to listening to the perceived value of these stocks thrown around in general stock-trading conversations can give a much better insight into how companies in a given industry are performing with regard to one another, and which ones to invest in. It is important to note that these numbers should always be compared with those of companies of the same industry for a more accurate measure. 

Companies with lower values or undervalued stocks are generally the way to go as they may signify a better potential for future returns, once their true values are realised.  

2. Price-to-Earnings (P/E) ratio:  

The second important metric we will take a look at is the Price-to-Earnings ratio. As the name suggests, the numerator of this ratio is the same as the value of P as discussed above, i.e. the market value of each stock, but the difference lies in the earnings aspect. 

Instead of considering the book value when going through the balance sheet of a company, this time we will consider the profit and loss statement, or the income statement of the company to find the profit margin. Dividing this team with the number of shares is the value we will use to divide the market value of each share with. 

Let us assign the letter E for the denominator of the ratio we want to looking at. Therefore, E = profit made/number of outstanding shares 

Thus, the Profit-to-Earnings ratio = P/E 

How this ratio is helpful: 

This ratio is quite important, in fact, even more so than the P/B ratio, as a desired number here dictates whether the company is actually making money, which is a pretty good indicator of whether the stock prices will stay up, if they aren’t already. There are also places where the ‘E’ is replaced with projected earnings instead of recorded earnings from the past, which could possibly be a better indicator of how the company’s shares are going to be valued per unit of profit on one share, but those numbers are not as objective as recorded earnings from the past. 

A high P/E value means that the company is expected to earn more than it is by investors, but a low value could be vital to look at as it could mean the company is doing well in terms of earnings but is undervalued, which is something to watch out for when comparing stocks. As with the previous factor (P/B), comparisons of ratios with those of only similar companies in the same industries need to be made to reach a meaningful conclusion. 

3. Price-to-Earnings growth (PEG) ratio: 

If you have managed to calculate the above metrics, the PEG ratio should be simple enough to understand and calculate. It is simply the P/E ratio of the company you want to evaluate, divided by the growth rate of its earnings.  

PEG ratio = (P/E)/Growth rate over a period  

The growth rate considered is usually taken as a yearly figure. Also, when projected growth rates instead of actual growth rates are used for the calculations, the figures are usually known as Forward PEG ratios and Trailing PEG ratios when it is the other way around. 

How this ratio is helpful: 

When the PEG ratio is lower amongst companies of the same industry or sector, it usually means that the company in question is doing well with respect to its growth. For forward PEG ratios with lower values, it means the company is expected to perform better in the future, and these are the companies to be desired. 

4. Dividend Yields: 

The dividend yield is quite a simple concept to describe, but not so simple beneath the surface as dividends can also vary.  

Annual Dividends are the amount that shareholders receive for owning a stock from a given company. The Dividend Yield, on the other hand, is a percent of the individual stock price, i.e. the amount receivable for the individual stock’s price. 

Obvious as it is, a higher percent here is desirable and companies that pay out good dividends to shareholders are another factor to consider along with those described above in evaluating stocks. 

Conclusion 

These four measures are ineffective when used alone,
but when a holistic understanding is gained with respect to all 4 factors combined,
they may provide an investor with a considerably more accurate picture of the stock’s value. Taking the help of a financial advisor or stock tips provider could be beneficial as well as they have expertise in these fields. They might also provide you with the best advice on which stock to invest in and in which to not, but even they can only go so far in painting a fairly easy-to-understand picture of stock valuations unless you do your homework first. 

Also, even though this article focuses on being simple to understand in layman’s terms, we can’t stress enough on how important it is to know each of the terms described above in a way that can be utilized in our daily interactions with the market, as they can help us stay ahead of the curve and see potential where others don’t. So don’t be shy in geeking out over these terms!