Investors may use different stock valuation methods when evaluating stocks, depending on data availability and individual preference. Evaluating stocks mainly involves determining a stock's intrinsic value as the investor sees it, and comparing the stock's value with the stock's price as quoted in the market. The purpose of such evaluation is to decide whether a stock at its current trading price is fairly valued, overvalued or undervalued by the market. This provides investors a fundamental basis regarding whether to hold, sell or buy the stock. Data used in different stock valuation methods include dividends, earnings and book value, often expressed on a per-share basis. Investors may also use a particular valuation method in specific situations in which precise evaluation or quick estimate may be needed.
Discounted Dividend Method
Similar to the discounted cash flow model used in many other asset valuation, the discounted dividend method assumes that a stock's value is the present value of a stock's future dividends discounted at an investor's required rate of return. The larger a stock's expected future dividends each year and the less risky those dividends will be distributed, the higher the stock's value is according to the investor performing the valuation. The discounted dividend method is the most conceptually correct and a more precise way of evaluating stocks, but it can also be subjective as not all investors would view a given company the same all the time. The discounted dividend method involves estimation of both the amount of future dividends and the riskiness of actually receiving the dividends. An investor who's more optimistic about a company's future earnings and perceives little risk of dividend suspension by the company would likely place a higher value on the company's stock and be willing to settle on a lower rate of return.
Price to Earnings Ratio
Price to earnings ratio, or P/E ratio, is another stock valuation method, both wildly referenced in financial market reporting and frequently used by investors. The P/E ratio is a numerical multiple expressed as a stock's price divided by the stock's reported earnings per share. There are two reasons that the P/E ratio often is used as a substitute for the discounted dividend method in stock valuation, despite its lack of preciseness. First, when a company retains all its earnings and doesn't pay out dividends, which is true for many growth companies and companies with ample investment opportunities, the discounted dividend method becomes inapplicable. By comparing a stock's price to the company's reported earnings, investors are still able to base a stock's value on its overall earnings ability. Second, the use of P/E ratio provides a quick estimate about a stock's value that can be then compared to industry average and a company's own historical average to determine how the stock's value fares.
Price to Book Ratio
Price to book ratio can be especially meaningful to value investors as it compares a stock's price directly to a company book value. Book value is the net asset value after deducting total liabilities from total assets, also known as the value of shareholders' equity. Price to book ratio as a stock valuation method is also useful for investors of companies that are experiencing net losses and thus don't have any reported earnings. Absent dividends and earnings, the use of either the dividend method or the P/E ratio becomes impossible. But earning no profits from time to time doesn't mean that a company has no value completely. The use of price to book ratio provides investors an alternative way to evaluating a company's stock based on reported equity value on the company's books.
Discounted Dividend Method
Similar to the discounted cash flow model used in many other asset valuation, the discounted dividend method assumes that a stock's value is the present value of a stock's future dividends discounted at an investor's required rate of return. The larger a stock's expected future dividends each year and the less risky those dividends will be distributed, the higher the stock's value is according to the investor performing the valuation. The discounted dividend method is the most conceptually correct and a more precise way of evaluating stocks, but it can also be subjective as not all investors would view a given company the same all the time. The discounted dividend method involves estimation of both the amount of future dividends and the riskiness of actually receiving the dividends. An investor who's more optimistic about a company's future earnings and perceives little risk of dividend suspension by the company would likely place a higher value on the company's stock and be willing to settle on a lower rate of return.
Price to Earnings Ratio
Price to earnings ratio, or P/E ratio, is another stock valuation method, both wildly referenced in financial market reporting and frequently used by investors. The P/E ratio is a numerical multiple expressed as a stock's price divided by the stock's reported earnings per share. There are two reasons that the P/E ratio often is used as a substitute for the discounted dividend method in stock valuation, despite its lack of preciseness. First, when a company retains all its earnings and doesn't pay out dividends, which is true for many growth companies and companies with ample investment opportunities, the discounted dividend method becomes inapplicable. By comparing a stock's price to the company's reported earnings, investors are still able to base a stock's value on its overall earnings ability. Second, the use of P/E ratio provides a quick estimate about a stock's value that can be then compared to industry average and a company's own historical average to determine how the stock's value fares.
Price to Book Ratio
Price to book ratio can be especially meaningful to value investors as it compares a stock's price directly to a company book value. Book value is the net asset value after deducting total liabilities from total assets, also known as the value of shareholders' equity. Price to book ratio as a stock valuation method is also useful for investors of companies that are experiencing net losses and thus don't have any reported earnings. Absent dividends and earnings, the use of either the dividend method or the P/E ratio becomes impossible. But earning no profits from time to time doesn't mean that a company has no value completely. The use of price to book ratio provides investors an alternative way to evaluating a company's stock based on reported equity value on the company's books.
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