Finding the Right Way to Value a Stock

Investing wisely means knowing what a stock is truly worth—and that means picking the right valuation method. There’s no one-size-fits-all, but here's how you can confidently choose the best fit.

Understand the Two Main Types of Valuation

• Absolute valuation tries to calculate the stock's "true value" using the company's own numbers, like cash flow or dividends. Think of it as figuring out what it's genuinely worth today. Popular models include:
  • Dividend Discount Model (DDM)
  • Discounted Cash Flow (DCF)
  • Residual Income or Asset‑based models

• Relative valuation compares the company to similar businesses using ratios like Price‑to‑Earnings (P/E), Price‑to‑Sales (P/S), or Price‑to‑Book (P/B). It asks: Is this stock cheaper or more expensive than its peers?

Choose Based on Company Traits

a) Is it a stable, dividend-paying company?
Use a Dividend Discount Model (DDM). The DDM calculates a stock’s value based on the present value of future dividends. It’s built on the idea that dividends represent the real cash flows going to shareholders.

Steps to Apply DDM:

1. Check if the company pays dividends regularly.
2. Assess whether dividends are stable and growing.
3. Confirm payout ratios are consistent.

Example:
If Company XYZ has increased its dividend by ~5% every year for the last six years, and earnings are stable, DDM is a suitable choice.

The Gordon Growth Model is a well-known version of DDM for companies with a constant dividend growth rate.

b) No dividends or erratic payments?
Try the Discounted Cash Flow (DCF) model. The DCF model values a company based on the present value of its projected future free cash flows. It’s versatile and can be applied to dividend-paying or non-dividend-paying companies.

Key Requirements:

• Positive and predictable free cash flows
• Reasonable visibility on future performance

Common Approach:

• Forecast free cash flows for 5–10 years
• Calculate a terminal value for the period beyond
• Discount all values back to today’s date

Example:
If a company’s free cash flows have been steady for several years, with limited volatility, the DCF method can give a realistic picture of its worth.

c) Need a quick comparison?
Use the Comparables (Relative) Model. Just look at relevant ratios—like P/E, P/B, P/S—and compare to similar companies. It’s fast, intuitive, and works well when fundamentals aren’t uniform.

3. Compare Both Approaches

• Absolute valuation gives a solid estimate of intrinsic value but takes more work.
• Relative valuation is faster and simpler—great for quick checks or comparisons

Why Market Price and Intrinsic Value Often Differ
Markets sway due to sentiment, sometimes irrational. Even if you calculate a stock's “fair value,” the actual market price may be higher or lower based on investor behavior, news, or future expectations.

Why Valuation Models Matter
Valuation methods help you decide:

• Is a stock undervalued and worth buying?
• Or overpriced, and perhaps time to sell?

They offer clarity in a noisy market

Fastest Way to Value a Stock
If you’re short on time, relative valuation is your friend. A quick look at a company’s P/E or P/S compared to peers can give an initial sense of whether it’s cheap or expensive.

The Bottom Line
There’s no single valuation model that works in every scenario. By understanding a company’s characteristics, you can choose the method that fits best. Investors aren’t restricted to using just one approach—many apply multiple models to estimate a value range or take an average of the results. In stock analysis, the goal isn’t always about finding the perfect tool, but about using a combination of tools to gain diverse insights from the numbers.