How to Value Shares of a Company

by George Boykin
All stock valuation techniques incorporate perceptions that are inherently subjective.

All stock valuation techniques incorporate perceptions that are inherently subjective.

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Several techniques offer insight into the value of a company's stock. All valuation techniques, however, quantify the worth of a stock based upon "perceptions" of value held by those doing the valuating, which are inherently subjective. Thus, all valuation techniques reflect underlying subjective perceptions that can differ based on people's investment goals.

Valuation Approaches

The three basic approaches to financial valuations are the cost approach, the market approach and the income approach. The cost approach assumes that a buyer will purchase an asset for no more than an asset of equal usefulness. The market approach assumes that in free markets, supply and demand will drive the price of a stock to a point where the number of buyers and sellers balance. The income approach defines value as the net present value of a company's future free cash flows.

Cost Approach

Book value is commonly associated with the cost approach. It is the sum of all of a company's "tangible assets" — plant, property and equipment — after deducting accumulated depreciation. A company's "net capital value" reflects this book value, measured by the company's book of net tangible assets over its book of liabilities. Calculate the book value of a stock by dividing the net capital value by the number of outstanding share to arrive at a per share value. One book value limitation is that it fails to valuate intangible assets such as brand names, which can be substantial. For instance, the "Coca Cola" brand name was appraised at $65 billion in 2013.

Market Approach

The market approach reflects prices of publicly traded stocks. However, stock values are implicit in stock prices. The price/earnings ratio or P/E ratio is commonly used to better understand those values. Divide the price of a stock by its earnings per share to determine the P/E ratio. Publicly traded companies must report their earnings per share. In general, investors attach greater value to stocks with higher P/E ratios. The average P/E ratio was 20-25 times earnings in mid-2013. Hence, P/E ratios above 25 times earnings identified stocks that investors held in high regard. Because there are several P/E ratios and variations thereof, you must know which ratio is in play. For example, the forward-looking P/E ratio is based upon "projected" future earnings, which are based on assumptions that may prove false.

Income Approach

The income approach holds that the value of a company equals the present value of the sum of its expected future income streams. The capitalized cash flow method is generally used to compute a company's worth when future income streams are expected to remain unchanged from the past. The discounted cash flow method is used when income streams are expected to fluctuate. Divide the resulting figure from the CCF or DCF calculation by the number of outstanding shares to determine the share price. Spreadsheet programs like Excel can do the DCF calculations for you. Simply plug in the numbers.

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