How to value a stock or a company – basic valuation
The content of this article
Valuation of stocks is a complex process. In the valuation of stocks, lots of different aspects come into play. In this article, we will go through the basics and how to think to create a quick overview of the valuation of a stock.
Examples of factors that affect the price and valuation of a company and its stocks
Company-specific factors that affect the valuation of a stocks
– The company’s turnover
– The company’s profit
– The company’s historical turnover and its increase / decrease
– The company’s historical profit and its increase / decrease
– The company’s indeptness
– The company’s cash flow
– The company’s products (do they have any future?)
– The company’s management
– The company’s ownership structure
General factors for the entire stock market that affect the valuation of a stock and the underlying company
– Current market situation (risk on or risk off)
– The economy (business cycle)
– Interest rate
– Unrest in the world
– Unrest in the industry in which the company operates
As you can see above, there are lots of factors that affect the valuation of a stock. The examples you see above are just a selection of all the factors that come into play. There are even so many factors that it is impossible to list them all. This is what makes it so extremely difficult to predict how the price of a stock will move forward over time.
As we mention above, we will only go through the basics around the valuation of stocks and companies. Most people should know these parts and if you know these cornerstones, you can quite quickly get an idea of whether a stocks is expensive or cheap right now.
Basic valuation of stocks and companies
The P/E ratio is a so-called multiple that is used extensively. A P/E ratio is the figure that is obtained when you divide a company’s price per share by the company’s earnings per share.
One share costs USD 100 in the Swedish company Volvo AB.
During 2016, Volvo made a profit of USD 10 per share (as an example).
100 / 10 = 10
The P/E ratio for Volvo is then: 10
You can then compare the number 10 with other similar companies operating in approximately the same industry. In this case, we are talking about an engineering company so it is good to compare with other engineering companies. If, for example, the company Scania, which is Volvo’s competitor, is valued at 15 times the annual profit, Volvo looks to be cheap. Or?
No it’s not that simple unfortunately. The market (buyers and sellers of stocks) estimates that Scania should be valued at P/E 15 while the market at the same time thinks that Volvo is only worth P/E 10.
What then is this due to? Well, the market then judges that Scania’s future prospects look better than Volvo’s. The market believes in the probability that Scania will grow more or become more profitable in the future than Volvo. So to compare, one should look at more factors that in this case differentiate the different companies. Obviously, this is something that makes Scania’s stocks valued higher.
Growth is the measurement of how fast a company grows. If you only use the word growth, you are talking about the company’s sales. If you put the word profit in front, you talk about profit growth. It is the measurement of how quickly a company increases its profits. Imagine two companies that are identical, company A and company B. Company A grows by 10% per year and company B grows by only 5% per year.
The stocks for company A will then be valued much higher than company B.
There are several types of growth. A company can create growth by buying other companies. This is called acquisition-driven growth. The one we focus on in the basic factors is organic growth. This means that the company increases its sales by selling more of its own products. The growth in a company controls the valuation of the stocks very, very much. Expectations of future growth can also increase the market’s valuation of a share extremely much.
The company’s profit is a very important parameter to take into account when valuing a stock. A company can have a sky-high turnover but still not make a profit. The company’s profit through sales in % is called the profit margin. It can be said that the profit margin is the company’s ability to turn sales into profit. It is also important to look at a company’s historical profit development.
If the company is stable and, year after year, increases its profit at the same time as sales rise, it is a clear sign of strength for the company. If the company also manages to maintain its profit margin or even manages to increase the profit margin, it is enormously strong. The market will love this and the valuation of the stock will pull upwards. The more years that a company succeeds in proving that it can increase sales and / or profit as well as the profit margin, the more the stocks price will rise. The market rewards companies with a positive stable development with a high valuation.
Example of a valuation of stocks
Company A has over the past 10 years proven that it has succeeded in growing by 10% per year over the past 10 years. At the same time, it has managed to maintain its profit margin of 10% during all years, so profits have grown in line with sales. The market loves this company. It is considered stable and you see it as a winner. The company is then rewarded with the stocks being valued at P/E 20 (as an example).
The same company A, but in this case the company’s turnover has increased by 10% per year at the same time as the profit margin has fallen each year down to 5%. The market then assesses that the company has difficulty growing and making money at the same time. The stocks is then penalized with a valuation of P/E 12. Small differences can make a big difference to the market’s valuation of a share in the end. The history of a company has a great impact on the price of the share..
Companies with low growth and high dividends
Dividend is the amount that a company distributes to its shareholders.
Company A has made a nice profit in 2016 of 1 billion USD. It is then decided at the Annual General Meeting that 10% of the profit shall be distributed to the shareholders. If the company then has 100 million external shares, each share will receive a dividend of USD 1. If you own 1,000 shares in company A, you will receive USD 1,000 paid into your account during that year.
There are some companies that are growing slowly but they make lots of money every year that they pay out to their shareholders in dividends. These are often called a “cash cow”. An example of a cash cow is McDonalds. They have only a few percent in annual growth. Since McDonalds still makes good money every year and distributes these to its shareholders, there is still a nice value in the company’s stocks.
Companies with low growth but with a good and stable profit can often be valued at low P/E ratios when the stock market is generally valued at high P/E ratios. Dividends are something that is appreciated by the market and a good stable dividend history often leads to a slightly higher valuation of a company, but if growth is low, the valuation will still be kept at lower levels.
Market situation, interest rates and psychology
One factor that has a huge impact on a stock’s value is psychology. There are plenty of books on how to understand the psychology of the stock market. Learning stock market psychology requires years of training and interest. It is too complicated for us to deal with this topic in this article focusing on basic factors.
The interest rate situation controls the stock market with an iron fist. Simply described, it can be said that low interest rates benefit the stock market, while high interest rates are negative for the stock market and the valuation of stocks. If the interest rate is low, it is cheap to borrow money to invest. This makes more people want to invest and it makes share prices rise. The companies then also borrow money to expand their operations, which also leads to the price of the share rising on the hopes that these investments will bear fruit.
When interest rates rise, it becomes more expensive for companies and also for private individuals to invest money. This means that it no longer looks as bright in the future for companies to increase their profits and turnover. The interest rate is an extremely important factor to take into account when valuing a company and its stocks.
“If it had been easy to value companies, we would all be rich” – Andreas H