How to value a stock (without losing your mind)

The value of your investments and the income you receive from them can go up and down, and you may get back less than you invest. Any examples are for illustration purposes only.

You like the business model, the company’s making money, the store count is expanding and margins look healthy. Your investment research has got off to a cracking start but, after the business itself has got the thumbs up, there still lies the all-important question: what’s the company actually worth?

Valuing a stock is a bit like shopping in the cereal aisle - you’ve got the fan favourites, the basics that never seem to change and the new boxes packed with ingredients apparently about to change your gut health forever. And, with all the special offers, premium ranges and supermarket own brands, it’s our job to figure out which of the bunch are worth buying. Sometimes that means comparing sugar content figures and free gifts, other times it means assessing a particular box on its own merits.

Investors are used to seeing share price charts with lines shooting off in all directions. When we value a stock, we’re trying to work out whether the current share price accurately reflects everything going on inside the business or if there’s a disconnect between the two. For most investors, finding a company whose shares are trading below the value of the business is the name of the game. Over the long term, shares tend to gravitate towards a company’s earnings trajectory so the theory is that buying when there’s a discount could prove fruitful if they rise to match the level of earnings. Buy at too high a level and any reversion over the long term could mean you lose money.

Read more:

- Do I need to get every stock pick right?

- Why valuations matter, even in tech

- The dividend investor’s checklist

We’ll come on to valuing a company on its own steam further down but it’s worth starting with a few valuation ratios you’re likely to see most often. These are relative valuation measures and work best when you compare them against the same measure in a company’s history, to the rest of the companies in the sector and to the market as a whole. The goal here is to get a quick idea of how a firm’s share price compares to its various metrics like earnings, sales etc., and if that’s in line with the wider world or markedly different, and if it potentially presents a buying opportunity.

Price-to-earnings (P/E) ratio

An old-school classic, the P/E ratio pits a stock’s price against the company’s earnings in a bid to see if investors are getting ahead of themselves or are ignoring an earnings machine.

The P/E ratio essentially tells us how much investors are currently willing to pay for £1 of a company’s earnings. We work it out like this:

P/E = share price / earnings per share

A P/E of 15 (often expressed as ‘15x earnings’) means the market is currently paying £15 for every £1 the company earns. How does that sound? Well, if sales are growing rapidly and peers are trading on 20x earnings, it might be worth investigating. If sales are trickling, maybe not.

We often find high P/E ratios attached to high-growth sectors because investors are willing to pay up for what they see as huge earnings streams down the road. The tech sector has had eyewatering P/Es in the past for this reason. You’ll typically find the opposite in the oil sector, with low growth reflected in low P/Es.

What we need to keep in mind is that high valuations need to be supported by earnings to keep those expectations alive. If shares are flying but earnings really aren’t delivering, the P might just come down to meet the E. The important thing is to compare apples to apples. Looking into a firm’s historical P/E to see how the current one measures up is sensible, comparing a tech startup to an oil giant isn’t.

All in all, the P/E should give you a jumping off point, from which to start looking at whether a high ratio is a red flag or not, or a low ratio is a buying opportunity or a sign of worse to come.

Earnings aren’t the only game in town, so here are some other key measures to look at. The theory is the same (apples to apples) but these will help fill in the blanks after you’re done with the P/E.

Price-to-sales (P/S) ratio

If you’re looking at a company that’s growing quickly or hasn’t made a profit yet, P/S can be a handy tool in the toolkit. Divide the share price by the sales per share to see what investors are willing to pay for £1 of company sales. It helps give perspective to the likes of a company losing money today but doubling its sales every year, and whether that sales growth is already factored into the share price or not.

Price-to-book (P/B) ratio

Some sectors come with asset-heavy companies. Banks, insurers and real estate firms carry chunky tangible assets and ledgers full of loans and mortgages. This makes them different to sectors in which brand value plays a key role.

P/B comes in handy to give an idea of what the former type of business would be worth if it shut up shop, met its liabilities and had to sell the family silver. A P/B of one tells us the share price is equal to this book value. Lower P/Bs might be a sign the company is undervalued, higher P/Bs might suggest the opposite.

Free cash flow

After a business has paid for everything it needs to operate, what it’s left with is the free cash flow. This is the cash the company could use to pay dividends, buy back shares or swim around in like Scrooge McDuck. Cash is king after all and seeing how much is piled up to help grow the business is a good start.

Discounted cash flow (DCF): back to the financial future

This one does exactly what it says on the tin. It helps us look at the cash a company is likely to generate in the future, and work backwards to see what we should pay today for a piece of that growth.

It’s quite like if your friend offered to give you £100 in five years’ time. Granted, that’s a nice friend to have but there are a few reasons that doesn’t exactly mean the same as receiving £100 today. Inflation between now and then means what you’ll actually be able to buy with the money will be reduced. Then there’s risk - what if you fall out? What if they jet off to a desert island or need the money too much to part with it by then? Then there’s the opportunity cost. If you had that £100 today you could invest it, fund your Etsy page or stick it in savings. Waiting for five years means missing out on those possibilities. All of these factors need to be accounted for in working out what that end amount is worth today, which means today’s value is usually lower.

Step 1: Estimate future free cash flows Given a company’s current and previous ability to produce cash, have a reasonable stab at what it is likely to generate each year over the next 5-10 years.

Step 2: Choose a discount rate This is the opportunity cost we mentioned above - the return you might expect if you invested somewhere else. A rate of 5-10% is often used to mimic what you might get from government bonds or equities.

Step 3: Calculate the present value of each year’s cash flow Cash in the future is great. Cash now is better. You can discount each future cash flow back to today’s money like this:

Present value = future cash flow / (1 + discount rate)^n

Where n = the number of years into the future.

Step 4: Add it all together Total up the present values of each year’s cash flow. Then add the present value of a terminal value. This is the estimated value of all cash flows beyond your forecasted time period (because, hopefully, your company doesn’t go kaput after 10 years).

We’ll use the perpetuity growth method which assumes the company keeps growing at a slow and steady pace forever. Think of a big consumer staples company that keeps churning out everyday essentials.

The formula here is:

Terminal value = last forecasted cash flow x (1 + g) / (r - g)

Where:

Last forecasted cash flow = the cash flow in the final year of your forecast

g = the growth rate you think the company can maintain forever (typically 2-3%, in line with inflation targets)

r = the discount rate

Once you discount those future cash flows back to present-day money and add it all up you’ll get the intrinsic value of the company. If that value is higher than the current share price, you might be on to something. In any case, you’ll now have a yardstick for what you’re prepared to pay for a piece of that company.

DCF calculations are sensitive

Small changes in the likes of your discount rate or growth guesswork can have big effects later for your valuation. It’s a good idea to use conservative figures or, better still, use a few different blends to give you a range of valuations based on different ideas about growth over the years.

If you find yourself being swayed simply by share price movements, valuations should help provide context so you don’t react rashly and buy or sell on a whim. They can provide a bit of backup to why you think a share offers good value or has become detached from its earnings enough to warrant a sale.

There will always be investors backing stocks with monstrously high P/Es or touting bargain basement P/Es as uncut gems though, so it pays to take a step back and ask yourself “Does this price make sense?”

Don’t get caught up in hysteria or extrapolating one-off results far into the future. Remember, you’re trying to identify underpriced or reasonably priced opportunities today, not betting the house on something that may or may not work out in a few years.

If in doubt, remember that valuations are just there to provide a bit more information than what the share price alone is telling you. The more you can do to put that price in the context of history, the wider sector and the market as a whole, the more informed you can be when it comes time to invest or move on.

Important information

When investing, your capital is at risk. The value of your investments, and the income you receive from them, can go down as well as up and you may get back less than you invest. Forecasts aren’t a reliable guide to future results or returns.

Make sure to do your own research on what investments are right for you before investing or consider seeking expert financial advice. Please note that this article is meant for information and does not constitute any financial advice. This is not an offer, recommendation, inducement or invitation to buy, sell, or hold any securities, or to engage in any investment activity or strategy.