There are two broad approaches to stock valuation. One is the ratio-based approach and the other is the intrinsic value approach. We will be looking at both of these in more detail later, focusing on the intrinsic value approach that we tend to favor at Morningstar. But here's a brief overview to get you oriented.
If you have ever talked about a P/E ratio, you've valued a stock using the ratio-based approach. Valuation ratios compare the company's market value with some financial aspect of its performance--earnings, sales, book value, cash flow, and so on. The ratio-based approach is the most commonly used method for valuing stocks, because ratios are easy to calculate and readily available.
The downside is that making sense of valuation ratios requires quite a bit of context. A P/E ratio of 15 does not mean a whole lot unless you also know the P/E of the market as a whole, the P/Es of the company's main competitors, the company's historical P/Es, and similar information. A ratio that looks sky-high for one company might seem quite reasonable for another.
The other major approach to valuation tries to estimate what a stock should intrinsically be worth. A stock's intrinsic value is based on projecting the company's future cash flows along with other factors, which we'll discuss in Lessons 403 and 404. You can compare this intrinsic or fair value with a stock's market price to determine whether the stock looks underpriced, fairly valued, or overpriced.
The advantage of this approach is that the result is easy to understand and does not require as much context as valuation ratios. However, the main disadvantage is that estimating future cash flows and coming up with a fair value estimate requires a lot of time and effort. We think the advantages outweigh the disadvantages when this type of valuation is done carefully. That is why it forms the basis of Morningstar's fair value estimates and star ratings.
The Bottom Line >>