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Morningstar.com's Interactive Classroom

Course 301
Valuing Stocks

Introduction

Valuing a stock is a lot like buying a car. There are lots of great cars out there, but the sticker price may be more than the actual worth of the car. Some manufacturers command a premium price because their cars have a certain cachet, not because their cars are necessarily more reliable or of better quality than others on the market. It's the same thing with stocks. Some stocks are valued much more richly than others because they're hot or popular with investors, not because the companies are more profitable or have better growth prospects. The ability to decide whether a company's stock price accurately reflects its performance is the heart of stock valuation.

What Is a Stock's Value?

The value of most stocks is a combination of the current value of the company and the value of the profits it will make in the future. In general, the more growth the market expects from a company, the more the company's market value will owe to expected future profits. Take online bookseller Amazon.com AMZN, for example. By most measures, Amazon has little or no current value; it has only minuscule book value and is gushing red ink. Liquidating Amazon today would leave its investors with zilch. But the market thinks the company's future profit potential is so bright that it has pinned a multibillion-dollar worth (the company's market capitalization) on the stock. Another way to think of a stock's value is that a company's stock price consists of a combination of what you're paying for the company's current level of profitability and what you're paying for its earnings growth. Since Amazon is far from profitable right now, the stock price is based almost entirely on expectations of future growth. That's one reason Amazon's stock is so volatile: As those expectations rise and fall, so does the price of its stock. In comparison, the stock price of copper-mining company Phelps Dodge PD largely reflects the company's current value, not its future growth. Phelps Dodge is quite profitable, but no one expects it to grow terribly fast.

Common Valuation Ratios

Let's look at the ways in which a stock's price compared with the value of the underlying company can be represented. Valuations are usually expressed as the ratio of a company's share price to an aspect of its financial performance, such as price/earnings (P/E), price/sales (P/S), price/book value (P/B), price/cash flow (P/CF), or price/estimated growth (P/EG). We'll take in-depth looks at some of these ratios in following courses, so don't worry if you're not entirely sure what they all are right now. We know that a stock's value is a combination of the company's present condition and its future prospects, and it is usually measured by a series of ratios. But how do we decide if that value is too high, too low, or just right? This is where things can get tricky, because valuing stocks is sometimes more an art than a science. That's why it is not uncommon for two analysts to look at the same company and come up with different conclusions.

Relative Valuation

There are two basic methods of valuing stocks. The most frequently used method is relative valuation, which compares a stock's valuation with those of other stocks or with the company's own historical valuations. For example, if you were considering the relative valuation for Dow Chemical DOW, you would compare its stock's price/earnings ratio (or its price/sales ratio, etc.) with that of other chemicals makers or with that of the overall stock market. If Dow has a P/E ratio of 16 and the average for the industry is closer to, say, 25, Dow's shares are cheap on a relative basis. You could also compare Dow's P/E with the average P/E of an index, such as the S&P 500, to see whether Dow still looked cheap. (With the S&P 500's P/E in the low 30s at the end of 1999, Dow was cheap all right.) The problem with relative valuations is that not all companies are made alike--not even all chemicals makers. There could be very good reasons why Dow has a lower P/E than its average peer. Maybe the company doesn't have the growth prospects of other chemicals companies. Maybe the possible liability from breast-implant litigation rightly puts a damper on the stock's price. After all, a Hyundai has a lower sticker price than a Mercedes, but for very good reasons. The key is to research your stocks well and be aware of the factors that might justifiably make them cheaper or more expensive than similar stocks.

Absolute, or Intrinsic, Valuation

The second basic method of valuing stocks uses absolute, or intrinsic, value. Usually, absolute value is estimated by calculating the present value of the company's future free-cash flows (cash flow minus capital spending). The present value of that future-income stream is the theoretically correct value of the stock. This method has its own difficulties and is less frequently used, but absolute value deserves a place in every investor's arsenal of valuation tools. Calculating the absolute value of a stock isn't easy. It's tough to forecast how fast a company's free cash flows will grow, how long they'll grow, and at what rate they should be discounted back to the present. At Morningstar, we estimate stocks' absolute values by inputting our estimates of a company's growth rate, profitability, and the efficiency with which it uses its assets into a discounted cash flow model. The result is an analyst-driven estimate of a stock's fair value in absolute terms.

In an imperfect world, opting for the much easier--if less pure--method of relative valuation often makes sense. However, when the companies you're using as your benchmark are themselves mispriced, relative valuation can lead you astray; without a reliable measurement tool, your measurements will be off. That last point can be crucial. If the S&P 500, for example, is trading at a P/E ratio that is very high by historical standards, using it as a benchmark can be hazardous. A stock can appear much cheaper than the overall market and still be quite expensive in absolute terms. So what's an investor to do? Unfortunately, there aren't any easy answers. The best way to approach stock valuation is by using many different methods, the same way you would if you were valuing a used car or a house. Checking out what similar houses in a neighborhood have sold for is akin to relative valuation, and walking through a house you're interested in--looking at the construction and quality of materials--is similar to intrinsic valuation. A judicious mix of both methods will serve you well.

Quiz 301
There is only one correct answer to each question.

1 The value of a stock reflects:
a. The current value of the underlying company.
b. The value of the underlying company's expected earnings over time.
c. A combination of 1 and 2.
2 What kind of company is most likely to have a volatile stock price?
a. A company with little current value but terrific growth prospects.
b. A company that has a high book value but only slow long-term growth.
c. A car manufacturer.
3 Which of these items is <em>not</em> an example of a risk related to using relative valuation?
a. The peers you are using for relative valuation may not be correctly priced.
b. The peers you are using may not be directly comparable to the stock you are valuing.
c. Valuation benchmarks are fundamentally arbitrary.
4 Deciding the value of a house in a neighborhood by looking at how much other houses in that neighborhood have sold for is most like:
a. Relative valuation.
b. Intrinsic valuation.
c. The Lynch method.
5 What is <em>not</em> a way to mitigate some of the problems associated with valuing a stock using only relative valuation?
a. Consider the fundamentals of the stock and its peers, as differences in fundamentals can go a long way toward explaining valuation discrepancies.
b. Look at more than one valuation benchmark.
c. Stick with low growth, high book-value stocks.
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