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# How to determine the fundamental value of a Stock

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#### Quibit

Senior Vice President - Equity Analytics

The most theoretically sound stock valuation method, called income valuation or the discounted cash flow (DCF) method, involves discounting of the profits (dividends, earnings, or cash flows) the stock will bring to the stockholder in the foreseeable future, and a final value on disposal.The discounted rate normally includes a risk premium which is commonly based on the capital asset pricing model.

In July 2010, a Delaware court ruled on appropriate inputs to use in discounted cash flow analysis in a dispute between shareholders and a company over the proper fair value of the stock. In this case the shareholders' model provided value of $139 per share and the company's model provided$89 per share. Contested inputs included the terminal growth rate, the equity risk premium, and beta.

Stock valuation methods
Stocks have two types of valuations. One is a value created using some type of cash flow, sales or fundamental earnings analysis. The other value is dictated by how much an investor is willing to pay for a particular share of stock and by how much other investors are willing to sell a stock for (in other words, by supply and demand). Both of these values change over time as investors change the way they analyze stocks and as they become more or less confident in the future of stocks.

The fundamental valuation is the valuation that people use to justify stock prices. The most common example of this type of valuation methodology is P/E ratio, which stands for Price to Earnings Ratio. This form of valuation is based on historic ratios and statistics and aims to assign value to a stock based on measurable attributes. This form of valuation is typically what drives long-term stock prices.

The other way stocks are valued is based on supply and demand. The more people that want to buy the stock, the higher its price will be. And conversely, the more people that want to sell the stock, the lower the price will be. This form of valuation is very hard to understand or predict, and it often drives the short-term stock market trends.

There are many different ways to value stocks. The key is to take each approach into account while formulating an overall opinion of the stock. If the valuation of a company is lower or higher than other similar stocks, then the next step would be to determine the reasons.

Earnings per share (EPS)
EPS is the net income available to common shareholders of the company divided by the number of shares outstanding. Usually there will be two types of EPS listed: a GAAP (Generally Accepted Accounting Principles) EPS and a Pro Forma EPS, which means that the income has been adjusted to exclude any one time items as well as some non-cash items like amortization of goodwill or stock option expenses. The most important thing to look for in the EPS figure is the overall quality of earnings. Make sure the company is not trying to manipulate their EPS numbers to make it look like they are more profitable. Also, look at the growth in EPS over the past several quarters / years to understand how volatile their EPS is, and to see if they are an underachiever or an overachiever. In other words, have they consistently beaten expectations or are they constantly restating and lowering their forecasts?

The EPS number that most analysts use is the pro forma EPS. To compute this number, use the net income that excludes any one-time gains or losses and excludes any non-cash expenses like stock options or amortization of goodwill. Then divide this number by the number of fully diluted shares outstanding. Historical EPS figures and forecasts for the next 1–2 years can be found by visiting free financial sites such as Yahoo Finance (enter the ticker and then click on "estimates").

Through fundamental investment research, one can determine their own EPS forecasts and apply other valuation techniques below.

Price to Earnings (P/E)
Now that the analyst has several EPS figures (historical and forecasts), the analyst will be able to look at the most common valuation technique used, the price to earnings ratio, or P/E. To compute this figure, one divides the stock price by the annual EPS figure. For example, if the stock is trading at $10 and the EPS is$0.50, the P/E is 20 times. A complete analysis of the P/E multiple includes a look at the historical and forward ratios.

Historical P/Es are computed by taking the current price divided by the sum of the EPS for the last four quarters, or for the previous year. Historical trends of the P/E should also be considered by viewing a chart of its historical P/E over the last several years (one can find this on most finance sites like Yahoo Finance). Specifically consider what range the P/E has traded in so as to determine whether the current P/E is high or low versus its historical average.

Forward P/Es reflect the future growth of the company into the future. Forward P/Es are computed by taking the current stock price divided by the sum of the EPS estimates for the next four quarters, or for the EPS estimate for next calendar or fiscal year or two.

P/Es change constantly. If there is a large price change in a stock, or if the earnings (EPS) estimates change, the ratio is recomputed.

Growth rate
Valuations rely very heavily on the expected growth rate of a company. One must look at the historical growth rate of both sales and income to get a feeling for the type of future growth expected. However, companies are constantly changing, as well as the economy, so solely using historical growth rates to predict the future is not an acceptable form of valuation. Instead, they are used as guidelines for what future growth could look like if similar circumstances are encountered by the company. Calculating the future growth rate requires personal investment research. This may take form in listening to the company's quarterly conference call or reading a press release or other company article that discusses the company's growth guidance. However, although companies are in the best position to forecast their own growth, they are often far from accurate, and unforeseen events could cause rapid changes in the economy and in the company's industry.

For any valuation technique, it is important to look at a range of forecast values. For example, if the company being valued has been growing earnings between 5 and 10% each year for the last 5 years, but believes that it will grow 15 –20% this year, a more conservative growth rate of 10–15% would be appropriate in valuations. Another example would be for a company that has been going through restructuring. It may have been growing earnings at 10–15% over the past several quarters or years because of cost cutting, but their sales growth could be only 0–5%. This would signal that their earnings growth will probably slow when the cost cutting has fully taken effect. Therefore, forecasting an earnings growth closer to the 0–5% rate would be more appropriate rather than the 15–20%. Nonetheless, the growth rate method of valuations relies heavily on gut feel to make a forecast. This is why analysts often make inaccurate forecasts, and also why familiarity with a company is essential before making a forecast.

Price earnings to growth (PEG) ratio
This valuation technique has really become popular over the past decade or so. It is better than just looking at a P/E because it takes three factors into account; the price, earnings, and earnings growth rates. To compute the PEG ratio, the Forward P/E is divided by the expected earnings growth rate (one can also use historical P/E and historical growth rate to see where it has traded in the past). This will yield a ratio that is usually expressed as a percentage. The theory goes that as the percentage rises over 100% the stock becomes more and more overvalued, and as the PEG ratio falls below 100% the stock becomes more and more undervalued. The theory is based on a belief that P/E ratios should approximate the long-term growth rate of a company's earnings. Whether or not this is true will never be proven and the theory is therefore just a rule of thumb to use in the overall valuation process.

Here is an example of how to use the PEG ratio to compare stocks. Stock A is trading at a forward P/E of 15 and expected to grow at 20%. Stock B is trading at a forward P/E of 30 and expected to grow at 25%. The PEG ratio for Stock A is 75% (15/20) and for Stock B is 120% (30/25). According to the PEG ratio, Stock A is a better purchase because it has a lower PEG ratio, or in other words, you can purchase its future earnings growth for a lower relative price than that of Stock B.

Sum of perpetuities method
The PEG ratio is a special case in the Sum of Perpetuities Method (SPM) [3] equation. A generalized version of the Walter model (1956),[4] SPM considers the effects of dividends, earnings growth, as well as the risk profile of a firm on a stock's value. Derived from the compound interest formula using the present value of a perpetuity equation, SPM is an alternative to the Gordon Growth Model. The variables are:

P is the value of the stock or business
E is a company's earnings
G is the company's constant growth rate
K is the company's risk adjusted discount rate
D is the company's dividend payment
P = (\frac{E*G}{K^2}) + (\frac{D}{K})
In a special case where K is equal to 10%, and the company does not pay dividends, SPM reduces to the PEG ratio.

Additional models represent the sum of perpetuities in terms of earnings, growth rate, the risk-adjusted discount rate, and accounting book value.

Nerbrand Z
Given that investments are subject to revisions of future expectations the Nerbrand Z utilises uncertainty of consensus estimates to assess how much earnings forecasts can be revised in standard deviation terms before P/E ratios return to normalised levels. This calculation is best done with I/B/E/S consensus estimates. The market tends to focus on the 12 month forward P/E level, but this ratio is dependent on earnings estimates which are never homogenous. Hence there is a standard deviation of 12 month forward earnings estimates.

The Nerbrand z is therefore expressed as

Z = \frac{\frac{P}{H[P/E]} - E12}{stdev(E12)}
where H[P/E] = normalised P/E, e.g. a 5 year historical average of 12 month forward P/E ratios.

E12 = mean 12 month forward earnings estimates

stdev(E12) = standard deviation of 12 month forward earnings estimates.

A negative number indicates that earnings are likely to be downgraded before valuations normalise. As such, a negative number indicates a valuation adjusted earnings buffer. For example, if the 12 month forward mean EPS forecast is $10, the price of the equity is$100, the historical average P/E ratio is 15, and the standard deviation of EPS forecast is 2, then the Nerbrand Z is -1.67. That is, 12 month forward consensus earnings estimates could be downgraded by 1.67 standard deviation before P/E ratio would go back to 15.

Return on Invested Capital (ROIC)
This valuation technique measures how much money the company makes each year per dollar of invested capital. Invested Capital is the amount of money invested in the company by both stockholders and debtors. The ratio is expressed as a percent and one looks for a percent that approximates the level of growth that expected. In its simplest definition, this ratio measures the investment return that management is able to get for its capital. The higher the number, the better the return.

To compute the ratio, take the pro forma net income (same one used in the EPS figure mentioned above) and divide it by the invested capital. Invested capital can be estimated by adding together the stockholders equity, the total long and short term debt and accounts payable, and then subtracting accounts receivable and cash (all of these numbers can be found on the company's latest quarterly balance sheet). This ratio is much more useful when comparing it to other companies being valued.

Return on Assets (ROA)
Similar to ROIC, ROA, expressed as a percent, measures the company's ability to make money from its assets. To measure the ROA, take the pro forma net income divided by the total assets. However, because of very common irregularities in balance sheets (due to things like Goodwill, write-offs, discontinuations, etc.) this ratio is not always a good indicator of the company's potential. If the ratio is higher or lower than expected, one should look closely at the assets to see what could be over or understating the figure.

Price to Sales (P/S)
This figure is useful because it compares the current stock price to the annual sales. In other words, it describes how much the stock costs per dollar of sales earned. To compute it, take the current stock price divided by the annual sales per share. The annual sales per share should be calculated by taking the net sales for the last four quarters divided by the fully diluted shares outstanding (both of these figures can be found by looking at the press releases or quarterly reports). The price to sales ratio is useful, but it does not take into account any debt the company has. For example, if a company is heavily financed by debt instead of equity, then the sales per share will seem high (the P/S will be lower). All things equal, a lower P/S ratio is better. However, this ratio is best looked at when comparing more than one company.

Market Cap
Market cap, which is short for market capitalization, is the value of all of the company's stock. To measure it, multiply the current stock price by the fully diluted shares outstanding. Remember, the market cap is only the value of the stock. To get a more complete picture, look at the enterprise value.

Enterprise Value (EV)
Enterprise value is equal to the total value of the company, as it is trading for on the stock market. To compute it, add the market cap (see above) and the total net debt of the company. The total net debt is equal to total long and short term debt plus accounts payable, minus accounts receivable, minus cash. The enterprise value is the best approximation of what a company is worth at any point in time because it takes into account the actual stock price instead of balance sheet prices[citation needed]. When analysts say that a company is a "billion dollar" company, they are often referring to its total enterprise value. Enterprise value fluctuates rapidly based on stock price changes.

EV to Sales
This ratio measures the total company value as compared to its annual sales. A high ratio means that the company's value is much more than its sales. To compute it, divide the EV by the net sales for the last four quarters. This ratio is especially useful when valuing companies that do not have earnings, or that are going through unusually rough times. For example, if a company is facing restructuring and it is currently losing money, then the P/E ratio would be irrelevant. However, by applying an EV to Sales ratio, one could compute what that company could trade for when its restructuring is over and its earnings are back to normal.

EBITDA
EBITDA stands for earnings before interest, taxes, depreciation and amortization. It is one of the best measures of a company's cash flow and is used for valuing both public and private companies. To compute EBITDA, use a company's income statement, take the net income and then add back interest, taxes, depreciation, amortization and any other non-cash or one-time charges. This leaves you with a number that approximates how much cash the company is producing. EBITDA is a very popular figure because it can easily be compared across companies, even if not all of the companies are profitable.

EV to EBITDA
This is perhaps one of the best measurements of whether or not a company is cheap or expensive.[citation needed] To compute, divide the EV by EBITDA (see above for calculations). The higher the number, the more expensive the company is. However, remember that more expensive companies are often valued higher because they are growing faster or because they are a higher quality company. With that said, the best way to use EV/EBITDA is to compare it to that of other similar companies.

http://en.wikipedia.org/wiki/Stock_valuation

#### Rocky

Senior Manager - Equity Analytics

Welcome after a long break. I didn't know you are back in business!

#### Quibit

Senior Vice President - Equity Analytics

Rocky wrote:Welcome after a long break. I didn't know you are back in business!

Good to see you after many years, sure you haven't had trouble since of late. Lets march towards the profits which is in the horizon, I am sure you would have already sensed it!

#### SHARK aka TAH

Expert

So many posts with real essence in it.

Makes us proud to have you after a pause......

Hats off Q

_/\_

#### stevenapple

Assistant Vice President - Equity Analytics

Thanks Q. This is not a bit.

#### Sstar

Vice President - Equity Analytics

Wonderful basis to select shares.

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