When it comes to equity investments, stock valuation is probably the most important part of the process. Simply put, any investment combines the art and science of identifying mispriced assets. With respect to equities, we use fundamental as well as technical analysis. In this article, we’ll look at the different stock valuation techniques using fundamental analysis. We’ll also use some real-life examples to make the concept easy to understand.
Stock valuation: Three main methods
Different observers might place stock valuation using fundamental analysis into different buckets. Some may divide them into absolute and relative valuation categories. In this article, we’ll divide fundamental stock valuation techniques into three broad categories.
- Income approach: The method is also called DCF (or discounted cash flow approach). The basic idea is that any asset’s value is based on the future income streams that it would generate. Some assets like gold and other commodities can be an aberration, as they don’t generate any regular income.
- Asset approach: The basic premise behind the asset approach is that any asset’s value should be seen in conjunction with its replacement value. The approach is particularly useful when a company has high tangible assets but little income from those assets.
- Market approach: This method of stock valuation is also known as relative valuation. To value any asset such as stocks, we should compare the valuation with other assets in that space. Because size varies across companies, we use ratios. For this reason, this method is also called ratio analysis.
Berkshire Hathaway chair Warren Buffett is among the most well-known value investors. Please read What the Buffett Indicator Says about Aramco’s Valuation for more analysis.
Fundamental analysis using different techniques
In general, retail investors use the market approach for stock valuation. The income and asset approaches are more technical. Typically, institutions use these stock valuation techniques when they intend to buy a company in full or in part. Let’s look at these fundamental stock valuation techniques in detail.
Stock valuation using DCF
In discounted cash flow (or DCF) analysis, we determine the fundamental value of a business based on the future cash flows generated by the company. The most commonly used proxies for cash flows are EBITDA, net income, and free cash flows. The dividend discount model of stock valuation would also fall under this category.
The theoretical background behind using these methods is that we invest in businesses for their future cash flows. In other words, we estimate how much the business is expected to earn over a particular timeframe. We can discount these cash flows to their present value using the appropriate discount rate that reflects the riskiness of the business.
The industry calls the discount rate the weighted average cost of capital or WACC. DCF analysis gives us an intrinsic value for the business. The problem related to this method is in forecasting future cash flows and the valuation’s sensitivity to terminal cash flows. Currently, the dividend discount model appears to be more or less redundant.
That said, high dividend-paying stocks can attract a higher valuation. McDonald’s (MCD) could be a case in point where investors seem to be paying a high multiple, and its dividend could be among the reasons.
Fundamental analysis using the asset approach
In the asset approach of stock valuation, we look at the market value or the replacement value of the asset. In theory, asset prices should be near their replacement values. But in practice, this is a less commonly followed approach, as it’s not easy to find an asset’s market value in the absence of a ready market for such assets.
Typically, companies report their assets at cost value, so it’s also difficult to calculate the replacement values. Each business features a variety of unique characteristics that include the brand, customer loyalty, and patents. This approach might not account for these characteristics.
Asset-based valuation: Freeport-McMoRan
We can use an offshoot of the asset-based stock valuation method to do some of the part valuation for asset-heavy industries. In 2015 and early 2016, copper mining stocks fell sharply amid concerns over China’s slowdown. At that time, Freeport-McMoRan (FCX), the leading US-based copper miner, sold some of its copper assets at a valuation that was above its then-prevailing valuation.
While equity markets didn’t appreciate Freeport’s copper assets at that time, third-party buyers took its copper assets into account rather than Freeport’s prevailing market valuation. Notably, buyers valued Freeport’s assets based on projections of long-term copper prices. However, equity markets expressed more concern over the short-term slump in copper.
Generally, institutions use income- and asset-based stock valuation techniques. Aspects like terminal value, WACC, and replacement values might not be familiar to many retail investors. Furthermore, it can be a cumbersome exercise to calculate these metrics.
Most retail investors, as well as sell-side analysts, focus on the market approach. Most investors and analysts look at metrics like the PE ratio, PEG ratio, and EV-to-EBITDA ratio to value stocks. Fundamental analysis using the market approach is the most common technique.
Generally, banking stocks are valued using the market price-to-book value ratio. In a way, this metric functions as a combination of asset-based and market-based approaches.
Stock valuations: Looking at the comp set
Along with standalone valuation, we can use the market approach to fundamentally value stocks on a relative basis. We can compare a stock’s valuation to other comparable companies (or comps). The basic philosophy behind relative valuation is that similar assets should trade at similar prices. There should not be a major valuation difference between similar assets.
However, one should select the comp set with great care as an inappropriate comp set can provide a distorted valuation. For instance, while both Ford (F) and Tesla (TSLA) are automotive companies, we can’t consider them comps in a strict sense.
While using the market approach, we need to consider the appropriate ratio for a particular stock. Notably, relative valuation is a detailed study in itself, which we’ll explore for a future article. In the meanwhile, you can check out our look at the PEG ratio.