• Stock Strategies
  • Selecting a Valuation Method to Determine a Stock’s Worth

    by Robert R. Johnson , Stephen M. Horan and Thomas R. Robinson

    Investing is about earning a financial return. Valuation is at the heart of investing—you need to find a stock selling at an attractive price relative to its intrinsic or underlying value, otherwise your prospects for a financial return are poor.

    Wait, you say, that sounds like value investing and I am a growth investor. We feel this dichotomy is unnecessary. All investing is about identifying companies for which we expect to earn a handsome financial return. Why would we want to buy companies selling above their intrinsic value? We might be willing to buy them if the current price is equal to the intrinsic value, as a fair financial return would be expected. However, ideally we would prefer to find companies where the current price is well below intrinsic value. Whether you are a value investor or a growth investor, you are likely concerned about the price you are paying relative to intrinsic value (including the company’s growth prospects). All investors should therefore assess the value of the company using some valuation method and compare that value to the current market price. Doing otherwise is to speculate, not invest.

    All valuation methodologies are not created equal and no single method applies to all companies or works in all market conditions. Some valuation methodologies are more appropriate in certain circumstances and not in others. In this article, we examine different valuation methodologies and provide guidance for selecting the method most appropriate in particular circumstances.

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    Robert R. Johnson Ph.D., CFA, CAIA, is the president and CEO of The American College of Financial Services in Bryn Mawr, Pennsylvania.
    Stephen M. Horan is a managing director and co-leads educational activities at CFA Institute.
    Thomas R. Robinson , CFA, provides leadership to CFA Institute’s largest region, the Americas, which includes Canada, the U.S., the Caribbean and Latin America.


    Discussion

    Samuel Urso from FL posted over 2 years ago:

    Good article and examples.


    Jamal Abdel Jabbar from IL posted over 2 years ago:

    Recommended article to Equity Analysts


    Richard Thomas from FL posted over 2 years ago:

    Quoting the author, "An important assumption in using a relative valuation method is that the companies or index you are using for comparison purposes are fairly valued. If you feel the peer companies or index are overvalued, then relative valuation may not be an appropriate method." This raises the $64,000 question, How do you determine if the "peer companies" are fairly valued? Whatever method used to answer this question may also determine if the company in question is fairly valued as well.

    Surprised to see no mention of the PEG ratio in the discussion of the high-growth stocks like Facebook. PEG=P/E/G so for FB's forward P/E of 40 divided by its expected growth rate of 35% gives a PEG of 1.14 indicating FB is 14% overvalued. However, using FB's TTM P/E of 99, the PEG ratio indicates FB is selling at 283% of its intrinsic value. Purchasing at these levels might be considered as speculation that the greater fool theory will pan out.

    Boeing (BA). Earnings are expected to grow only 4% over the next year and then pick up to around 10-11% the next few years thereafter. With their dividend payout ratio of 32% being close to their 10 year historical average and not knowing their dividend payout policy, using 12% dividend growth may be a bit optimistic. Otherwise a good illustration of DDM valuation.

    Nice introduction to valuation but it would have been nice to see a little more depth in DCF and FCF computations and analysis.


    Mort Mazaheri from AZ posted over 2 years ago:

    This was a good analysis of various techniques.

    The problems is that most investors, even the savvy one do not have the access to the level of details for making decisions. Is it possible to develope equations for each set of approaches to simplify the process and labling them most likely, less likely, etc ?


    Manjunath Sharma from CA posted over 2 years ago:

    DCF model for Boeing is utter non-sense. Academics have pushed this DCF model for long time and it is being shunned by top B-schools. See Stephen Penman (Columbia University). If I follow his method of RIM and use EPS estimates (savings model), I can value any company and a range of values (with COC 8% to 11%) and abnormal earnings growth rate from 3% to 9%.


    JOHN from NEW YORK posted over 2 years ago:

    WELL DONE


    David Phillips from AL posted over 2 years ago:

    I would like to highly recommend the authors' book "Strategic Value Investing". It is the best book of this type because it lays a helpful foundation and builds on it in a logical progression.

    For those who aren't using Stock Investor Pro with the add-in program "xlq" by Qmatix you are missing the easiest way to perform fundamental analysis. I cannot say enough nice things about SIP and xlq. XLQ comes with a very comprehensive demo spreadsheet with helpful formats and examples, "AAII Demo". XLQ directly reads the SIP database and the program is easy to learn. http://qmatix.com/

    "We learn from each other and wind up teaching ourselves". James Beard, famous chef.


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