Stocks Basics: Valuing Stocks

There are two approaches to valuing stock.

  • RATIO-BASED APPROACH
  • INTRINSIC VALUE

RATIO-BASED APPROACH:

Valuation ratios compares the market value with financial aspects of its performance. It usually includes sales, book value, cash flows. Ratio-based approach is used for valuing stocks. Ratios are easy to calculate and are easy to read. For Example, the ratio that seems very high for one company, may seems very reasonable to other company.

INTRINSIC VALUE:

It is based on projecting the future cash flows of company. It also contains other factors. We can compare intrinsic value with a stock’s market price. It is used to check whether the stocks look under-priced, over-priced or fairly valued. Its main benefit is that it takes very less time in understanding. It does not take context as the valuation of ratios does.

The important things to hold about this difficult subject are the following:

1. At the most important level, supply and demand in the market usually determines stock price in any given moment.

2. Price times the quantity of shares outstanding, is the value of a company.  Just comparing the share price of two companies is pointless.

3. Theoretically, earnings are what affect valuation of investors of a company, but there are other indicators also that investors use to calculate stock price. It is sentiment of investor, attitudes and expectations that overall affect stock prices.

4. There are many opposing theories, that try to explain the way in which stock prices move the way they do. Unfortunately, there is no theory that can explain everything of it.

Because the future is unfamiliar today, various estimates of people will be different from one another, giving some a higher expected stock price and giving some a lower stock price. If the current price is lower than their expected price, then people will usually buy it. If it is higher, people will usually sell it. When an economy is growing, people are spending and usually profits are rising. Companies invest in projects, develop their businesses and hire more people. Investors are hopeful and expectations of future cash flows rise, and stocks enter usually enter a bull market. Simply putting, stock markets can fall when expectations of the future cash flows decrease, making the prices of companies seem to be very high, therefore ultimately causing people to sell shares. If more people come to this decision than there are definitely people to buy those shares, the price will fall until it reaches that level where people will begin to believe that they are valued fairly.

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