Stock valuation is very important part of investing in stocks, and this part is the most time consuming and knowledge requiring. Stock valuation is a necessary and main step at stock picking process. The only way for you to avoid this step, if you want to invest in stock market, is to invest in equity funds but not in stocks directly. If you are investing in mutual funds or index funds (ETFs as well) then you don’t need to pick each security by yourself, fund’s manager does that for you. And it may be the best way for you to invest in stock market if you don’t know much about finance and business and you don’t have time to get knowledge about it.
However, if you will invest only in funds, you cannot expect skyrocketing return of investments in your portfolio. Funds just don’t do that. They mostly reflect all the market and are investing only in the largest stocks. If you want to discover some stocks that would be real pearls, you can do that only by yourself. And there is only one real way for that (if ignore all the quack theories). That way is stock research and valuation. Your goal is to find some stock that is highly undervalued according to its fundamentals. That would mean that stock is very cheap according to its potential.
If you want to find such undervalued stocks, most of the time you have to carry out analysis by yourself. Of course, it is not hard to find a lot of researches and valuations on the market for free but the problems of those that such researches are made only for the biggest companies and everybody knows about them and you can’t always trust in publicly distributed researches. This is the reason, why you have to learn how to evaluate stocks by yourself.
Main Valuation Methods
There are three main valuation methods in theory of assessing: relative valuation, DCF valuation and replacement cost method. Those methods are useful not only for business valuation, but also for real estate properties and other asset valuation. All those three methods represent fundamental valuation and may be used in practice together, but only one method result can be used. You can’t take as a result an average of them all. The value might be used only from one method separately. All you can do, you may decide which method is most correct for the case. However, if the results are very wide (differs more than two times) that might mean that your calculations or assumptions are wrong and do not reflect market value.
It is needed a lot of practice until you will start to use any of stock valuation method correctly. If you think you are ready for that, then read about each stock valuation method:
RELATIVE VALUATION is the easiest and the most popular way to evaluate stocks. Relative valuation uses valuation multiples for comparison to other stocks. The main disadvantage of this method is that results are dependable on market moods.
DCF VALUATION shows stock target price (value) according to company’s cash flow. Cash flow of the company is forecasted for future period and discounted to current value. This method is more difficult than relative valuation and mostly is used by professionals.
RELPLACEMENT COST VALUATION is used mostly when above mentioned methods are not possible. This method calculates how much would cost to create an alternative object with the similar characteristics.