Our main goal as investors is to find good stocks and then sell them later for a profit. But for this, we need to find out stocks which are undervalued. There are different methods of valuation of shares that can help an individual know whether it is undervalued or overvalued. Today we will take a look at how we can find out if a stock is undervalued or not. So keep reading to find out.
Valuation – What Is It?
Valuation of shares refers to a process of knowing the value of a company’s shares. Valuation is done on the basis of quantitative techniques and the values will vary on the basis of market demand and supply.
Share prices of listed companies can be known easily. Sometimes even publicly-traded securities have to be valued as the market might not show the true picture. Valuation refers to an analytical process of determining an asset’s current (or projected) worth.
Undervalued stocks refer to those shares which have a price lower than their real – ‘fair’ – value. Stocks can be undervalued for several reasons, such as the recognisability of the company, negative news, market crashes, lower-than-expected results, etc.
On the other hand, overvalued stocks are the ones for which investors have high expectations. Such stocks trade at higher valuations and offer low dividend yields. These types of stocks are very popular in the marketplace.
Therefore, such stocks don’t offer much margin of safety since most investors are interested in purchasing them. Several techniques are used for doing a valuation.
An analyst who decides to place a value on a company takes into consideration the leadership team, composition of capital structure, future earnings, market value, etc.
Simply put, valuation is referred to the quantitative process of arriving at the fair value of an asset, investment, or firm. Valuations can get impacted as a result of corporate earnings or economic events.
Therefore, analysts have to keep updating their valuation methods. Even though valuations are quantitative in nature, it involves some level of subjective input or assumptions.
Reasons For Performing Valuation
Before jumping on the methods of valuation of shares, it is important to have a look at their importance. Valuations can prove to be instrumental when accomplishing objectives, and knowing the value of the business can act as a helpful and effective management tool.
Simply put, valuation means determining the present value of a company, investment, or asset. However, intrinsic value refers to a security’s perceived value based on future earnings.
Some of the common reasons valuations are conducted include M&A, strategic planning, capital financing, etc. Buyers and sellers tend to have a difference in the value of a particular business. Both parties will benefit from valuation at the time of making a decision.
A company should invest money only in those projects which can be beneficial in the long run. Hence, any sort of investment decision is a mini-valuation that is based on the probability of future profitability.
Valuation holds utmost importance at the time of making an investment in security, like a stock or bond. At the time of placing a trade, an investor essentially hopes that his/her investment will rise in value.
Therefore, he/she thinks that the current market price does not reflect its intrinsic value. Thus, a valuation becomes critical when an intrinsic value is required.
What Are The Methods Of Valuation Of Shares?
There are several methods of valuation of shares, and the decision should be taken only on the basis of the availability of data, the size of the company, or other factors.
Some of the methods include the asset-based approach, income-based approach, and market-based approach. Let us discuss these approaches in detail.
An asset-based approach is that approach that is useful for big companies having huge capital assets such as manufacturers, distributors, etc.
This is an approach that takes into consideration the company’s assets and liabilities. This method of valuation also includes contingent assets and contingent liabilities.
In this method, net asset value should be divided by the number of shares. Therefore, the value of each share is required to be determined. To calculate the net value of assets, external liabilities are required to be subtracted from the total assets of the company.
The second approach, the income-based approach, is used at the time of valuing a small number of shares. The advantages which are expected from the investment done in the business are calculated or valued under this method of valuation.
In other terms, analysts say that this is nothing but what businesses can generate in the near future. Under this method, the expected earnings of the company are divided by a capitalization rate.
Discounted cash flow method is the most commonly used method in the financial community. In short, in a DCF technique, an intrinsic value is calculated as an analyst forecast the company’s unlevered FCF into the future.
He/she then discount it back by using the company’s WACC. The market-based approach takes into consideration the share prices of comparable companies which are publicly traded.
This approach also considers the share values or asset values of private companies which can be compared. Nature and volume of business, relevant industry, company size, and financial condition are some of the measures on the basis of which comparable companies can be chosen.
In the market-based approach, analysts tend to prefer using two methods: Earning yield and Dividend yield.
The above methods of valuation of shares are widely being used in the financial industry in the current scenario. Valuation helps in assessing the fair market value of the company at the time of making investment decisions.
Therefore, we can conclude that the valuation of shares means the valuation of the company, its earnings, and its assets. Valuation helps in determining the value of investment of equity shareholders, and the growth which they can expect.
However, while choosing an appropriate valuation method, the ultimate purpose is required to be ascertained. Accordingly, a valuation method can be selected.
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