Stock valuation is the method of calculating the worth of a company’s stock based on historical and forecast data. Investors use stock valuation to determine if the price of a stock accurately reflects its true value. If the stock is undervalued then it is purchased in anticipation that it can be sold at a higher price in the future. If a stock is considered to be overvalued then investors will refrain from purchasing it or will sell current holdings before its price falls.
Price fluctuations may not coincide with the company’s true stock value, creating a gap. A significant gap between a stock’s value and price presents a profitable opportunity for keen investors until the price and value reach an equilibrium point. Investors can sell their stocks quickly if they consider them to be overvalued, or purchase stocks if they are undervalued so that a higher profit can be made when the price reaches its true value. These gaps are usually found quickly and reach equilibrium points before most investors even realize the discrepancy.
First steps of stock evaluation include examining the company’s cash flow and performing a sales or fundamental earnings analysis. A company’s stock price is influenced by supply and demand. As investors gain more confidence in the future of the company’s stocks, they purchase more, which reduces the supply and increases the price. As investors lose confidence in the company’s stocks, they start selling their holdings, increasing supply and reducing the price. Psychological factors should also be taken into consideration when comparing a stock’s price to its value, such as when a country is facing an economic crisis.
Ratios are a common method of stock valuation used by investors. Popular ratios include the price to earnings ratio, earnings per share, growth rate, price earnings to growth ratio, return on invested capital, return on assets and price to sales. Caution should be used when considering a ratio that includes a constant growth rate, since it is not likely the stock will grow at a constant rate forever. Other techniques include calculating the market capitalization and enterprise value. Investors also look at the earnings before interest, taxes and depreciation to compare individual companies against industry averages.
For stock valuation to be accurate, a technical analysis should be done in combination with looking at psychological factors that could be inflating or deflating the price. Investors use a combination of ratios and methods in order to determine a stock’s true value in order to find opportunities. Stock valuation requires time, patience and great attention to detail.