Stock Valuation PDF

# Stock Valuation ## Common Terms 1. Stock - portion of ownership of a corporation. 2. Common Stock - most basic form of ownership, including voting rights on major issues, in a company. 3. Market Value - current price of a share of stock in the stock market. 4. Book Value - value of a common stock...

# Stock Valuation ## Common Terms 1. Stock - portion of ownership of a corporation. 2. Common Stock - most basic form of ownership, including voting rights on major issues, in a company. 3. Market Value - current price of a share of stock in the stock market. 4. Book Value - value of a common stock expressed as the firm's owners' equity divided by the number of common shares. 5. Dividend - payment to shareholders, on a per-share basis, out of the company's earnings. 6. Blue-Chip Stock - common stock issued by a well-established and respected company with a sound financial history and a stable pattern of dividend payouts. 7. Mutual Fund - company that pools cash investments from individuals and organizations to purchase a portfolio of stocks, bonds, and other securities. 8. Exchange-Traded Fund - bundle of stocks or bonds that are in an index that tracks the overall movement of a market, but unlike a mutual fund can be traded like a stock. ## Stock Valuation - Is a method of determining the intrinsic value of a stock or a company's shares. - Every investor who wants to beat the market must master the skill of stock valuation. The importance of valuing stocks evolves from the fact that the intrinsic value of a stock may be different from its current price. - By knowing a stock's intrinsic value, an investor may determine whether the stock is over- or undervalued at its current market price. ## Types of Stock Valuation ### Absolute - Absolute, or intrinsic, stock valuation relies on the company's fundamental information. The method generally involves the analysis of various financial information that can be found in, or derived from, a company's financial statements. - Notable absolute common stock valuation techniques include the Dividend Discount Model (DDM) and the Discounted Cash Flow Model (DCF). ### Relative - Relative stock valuation compares the potential investment to similar companies. The relative stock valuation method calculates multiples of similar companies and compares that valuation to the current value of the target company. - The best example of relative stock valuation is comparable company analysis, sometimes called trading comps. ## Techniques in Stock Valuation ### Dividend Discount Model (DDM) - The DDM is based on the assumption that the company's dividends represent the company's cash flows to its shareholders. - Essentially, the model states that the intrinsic value of the company's stock price equals the present value of the company's future dividends. - Note that the dividend discount model is applicable only if a company distributes dividends regularly and the distribution is predictable. ### Discounted Cash Flow Model (DCF) - Under the DCF approach, the intrinsic value of a stock is calculated by discounting the company's free cash flows to its present value. - The main advantage of the DC model is that it does not require any assumptions regarding the distribution of dividends. - Thus, it is suitable for companies with unknown or unpredictable dividend distributions. ### Comparable Companies Analysis - Comparable companies analysis is an example of relative stock valuation. - Instead of determining the intrinsic value of a stock using the company's fundamentals, the comparable approach aims to derive a stock's theoretical price using the price multiples of similar companies. ## Stocks - **Intrinsic Value** - the perceived or calculated value of a company's stock based on fundamental analysis. Fundamental analysis involves evaluating a company's financial health, its earnings, dividends, growth rate, and other financial indicators to determine its underlying value. - **Market Price** - the current price at which an asset, commodity, or service can be bought or sold in a market. ## Intrinsic Value vs Market Price - Intrinsic Value > Market Price = undervalued - Intrinsic Value < Market Price = overvalued ## Risk Management - Tolerating the potential for losses. - The probability of an adverse outcome. - Uncertainty of future outcomes. ## Types of Risks ### Business Risk - Changes in demand. - Input prices. - Obsolescence due to technological advances. ### Non-Business Risk - Pandemic. - Behavior. - Compliance. ### Financial Risk - Movement of the market (fluctuation in interest rate). - Currencies and stocks/share prices. ## Types of Financial Risks ### Market Risk - **Price Risk:** The risk of losses due to changes in the market prices of financial instruments like stocks, bonds, commodities, and currencies. - **Interest Rate Risk:** The risk that arises from fluctuations in interest rates, affecting the value of fixed-income securities such as bonds. ### Credit Risk - **Default Risk:** The risk that a borrower may not repay a loan or meet its contractual obligations, leading to financial losses for the lender. - **Counterparty Risk:** The risk that the other party in a financial transaction may default, especially in derivative contracts. ### Liquidity Risk - **Asset Liquidity Risk:** The risk that assets cannot be sold quickly enough in the market without significantly affecting their prices. - **Funding Liquidity Risk:** The risk that a firm will be unable to meet its short-term financial obligations. ### Operational Risk - **Internal Factors:** Risks arising from internal factors such as inadequate processes, systems, people, or external events. - **External Factors:** Risks arising from external events like natural disasters, political instability, or technological failures. ### Currency Risk - **Transaction Risk:** The risk that arises from fluctuations in exchange rates between the transaction date and the settlement date. - **Translation Risk:** The risk that occurs when a company's financial statements are translated into a different currency. ### Commodity Price Risk - **Price Volatility:** The risk associated with fluctuations in the prices of commodities such as oil, gas, metals, and agricultural products. ### Investment Risk - **Concentration Risk:** The risk of significant loss due to a concentration of assets in a particular investment or sector. - **Managerial Risk:** The risk that the performance of an investment is affected by the decisions and competence of fund managers. ### Reputational Risk - **Public Perception:** The risk that negative public perception or publicity may damage the reputation of a company, affecting its market value and customer trust. ### Regulatory and Legal Risk - **Compliance Risk:** The risk of legal or regulatory sanctions, material financial loss, or loss to reputation a firm may suffer due to violations of laws, regulations, codes of conduct, or standards. ### Systemic Risk - **Marketwide Risk:** The risk that an event at the company or industry level may trigger severe instability or collapse of an entire financial system. ## Managing Risks - **Risk Appetite** - a broad description of the amount of risk an investor is willing to accept to achieve their objectives. - **Risk Tolerance** - is the practical application of risk appetite and considers the degree of variability in returns an investor is willing to bear. - Your age, income and investment objectives all help determine your risk appetite. - **Age:** generally younger investors with a longer time horizon to invest are more willing to take greater risk with their money to earn higher potential returns. - **Income:** people who earn more money and have a higher disposable income can typically afford to take greater risks with their investments. - **Investment Objectives:** be clear about why you're investing and when you think you'll need to withdraw your money, as well as how long you need the money to last. ## Type of Investments According to your Risk Appetite | Risk Appetite | Investments | |--------------|---------------------| | Conservative | Bonds, Savings Account, MP2, Time Deposit, Cooperative | | Moderate | REITs (Real Estate Investment Trust), Index Funds, Mutual Funds, Dividend Stocks, Rental Property | | Aggressive | Cryptocurrency, FOREX, Business, Growth Stocks, Real Estate | ## Rule of Thumb in Finance 1. Don't put all your eggs in one basket. 2. Invest according to your risk tolerance. 3. Invest for the long term. 4. Have an emergency fund. 5. Educate yourself before investing. 6. Don't let emotions drive your investment decisions. 7. Regularly review and rebalance your portfolio.