Valuing a stock correctly is the key success to value investing. Everybody knows the share price but little aware of its true value. In some cases, investors just don't bother the stock valuation. They buy stocks at any price but regret paying too much. And that should not be the case for value investor.In fact, Benjamin Graham who used to be Warren Buffet's guru wrote in detail on how to value stocks with his partner, David Dodd in their famous value investing bible, Security Analysis. The thing is, reading the book might take you years to finish.
The good news is, I'd simplify the stock valuation model for you to start straightaway!
How to Value Stock Using Discounted Cash Flow (DCF) Model
I bet you've heard this more than anything else. It gained popularity as a way to value stock following the stock market crash in 1929.
Anyway, this stock valuation model was about projecting the stock's future cash flow and discounting it back to present value using Weighted Average Cost of Capital (WACC). Be warned though that the term "cash flow" is not about cash the company has in balance sheet, but the operating profits (after deducting capital expenditure) the stock is making.
Though it can be the best stock valuation model so far, I find it tough for beginners to deal with the details. If you'd decided to use this method, you have to take into consideration the revenue growth and the increasing cost synchronously. Fail to do so results to wrong intrinsic value.
How to Value Stock Using Dividend Discount Model (DD)
This stock valuation model is perfect for high dividend yield stocks. The idea is to estimate future dividends based on the historical dividend payout and discount it back to current value.
Though it looks so simple, it works best for income type of investors.
However, the key ingredient for this stock valuation model to works is that the company must be strong, tough, and has proven track record of consistently paying dividend to shareholders. Otherwise, it is a waste of time.
How to Value Stock Using Earnings Growth Model (EG)
Earnings growth model is much easier than DCF model, but may not be as simple as DD model. And it works! It is so practical in stock market investing as nothing can beat earnings!
So how to value stock using this stock valuation model?
First of all, I did some forecast on the stock's future earnings using both constant and variable growth rate, depending on what I expect to happen along the way.
Stock market crash and economic boom are something I'll consider.
Later on, I discount the price to present value using both price to earnings ratio and expected annual return to calculate the intrinsic value of the stocks.
Spend time understanding all stock valuation models and you'll be ahead of anybody else in value investing.
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