Investing in the stock markets is not simple and it is risky, but in the other side there are many opportunities to make money by investing. Before investing in stocks, it is necessary to create a solid financial plan, to determine the risk profile, to analyze the stocks, to create an optimal portfolio etc.
One of the best methods to analyses the stocks is the fundamental analysis. It assesses the intrinsic value of a security by analyzing various macroeconomic and microeconomic factors. The ultimate goal of fundamental analysis is to quantify the intrinsic value of a security. Its intrinsic value can then be compared to its current market price to help with investment decisions. Let’s see now how to use the fundamental analysis to pick stocks.
How to calculate the intrinsic value of any stock in the market
The traders use many methods to determine the intrinsic value of the stock. Some of these methods are simple to use, others are more complex. The complexity of a method does not mean that the result is better. These are the main types of methods used in the fundamental analysis:
- Dividend discount models.
- Stock market multiples.
These methods were improved over the time, so now it is possible to obtain accurate and reliable results.
How to use the dividend discount models to quantify the intrinsic value
The dividend discount model (DDM) is used to evaluate the stock price based on the theory that its stock is worth the sum of all of its future dividend payments, discounted back to their present value. In other words, it is used to value stocks based on the net present value of the future dividends. The equation is:
The discount rate (k) is calculated using the CAPM Model. Over the years, other dividend discounting models have been developed, bringing changes to the initial model. Some of them are:
- Gordon growth model.
- Two stage model.
- H model.
- Three stage model.
Who use these models, attempts to measure a security’s intrinsic value by examining related economic and financial factors including the balance sheet, strategic initiatives, microeconomic indicators, and consumer behavior. Then the trader compared to its current market price to help with investment decisions. If the intrinsic value is lower than the market price, the stock is overvalued. If the intrinsic value is higher than the market price, the stock is undervalued.
How to use the stock market multiples to quantify the intrinsic value
Apart from the dividend discount models, many traders use price multiples for valuing the stocks. The multiples approach is a valuation theory based on the idea that similar assets sell at similar prices. The multiples ratio are very easy to calculate and can be quickly used for comparing stocks within a sector. Usually trader will compare the price multiple for a stock with a benchmark value based on an index or industry group. Commonly used equity multiples include:
- Price/Earnings ratio (P/E).
- Price/Book Value ratio (P/BV).
- Price/Sales ratio (P/S).
As the dividend discount models, the stock market multiples help, the traders to identify if a stock is cheap or expensive.