Valuation Basics

Valuation is the process of estimating what a business, or a share of it, is worth. A stock's price is what you pay; its value is what you get. Traders and investors use valuation to judge whether a stock is cheap or expensive, to understand what the market is assuming about the future, and to set expectations for returns. There is no single correct value, only estimates based on assumptions, but a disciplined approach helps avoid paying far too much.

Two main approaches#

Most professionals use both: intrinsic valuation to understand what drives value, and multiples to check against the market.

The core idea#

A company is worth the cash it will generate for its owners over its life, discounted back to today because money in the future is worth less than money now and because the future is uncertain.

value = Σ expected cash flow in year t / (1 + discount rate)^t

Three things drive value:

1. Cash flow today.
2. Growth in that cash flow.
3. Risk, reflected in the discount rate. See WACC and Cost of Equity.

Common valuation multiples#

Reading what the price implies#

Instead of asking "what is it worth?", traders often ask "what does today's price assume?"

Market cap and enterprise value#

market capitalisation = share price × shares outstanding
enterprise value = market cap + debt - cash (+ preferred stock and minority interests)

Enterprise value is the price of the whole business, including what is owed to lenders. It is used with measures like EBITDA and sales that belong to all capital providers. See EV/EBITDA and EV/Sales.

Why valuation is hard#

• Forecasts are uncertain, especially years ahead.
• Small changes in assumptions (growth, discount rate) cause large changes in value.
• Markets can stay "irrational" for long periods.
• Accounting differences distort comparisons.
• Quality matters: a great business can justify a high multiple. See Competitive Advantage and Moats.

Valuation and trading#

Valuation rarely times short term moves, but it shapes long term returns and the risk of large drawdowns. Very expensive stocks need excellent results to justify their prices, so disappointments can cause sharp falls; cheap stocks can rally on small positive surprises. Many traders combine valuation with technical analysis and catalysts. See Technical vs Fundamental Analysis.

Common mistakes#

• Calling a stock cheap because its price has fallen. See Anchoring.
• Comparing multiples across very different industries.
• Ignoring debt when comparing P/E ratios.
• Treating a model's output as precise.

Frequently asked questions#

What is stock valuation?#

Estimating what a company or share is worth, using approaches such as discounted cash flow analysis and comparisons with similar companies.

What is the difference between intrinsic and relative valuation?#

Intrinsic valuation estimates value from a company's own future cash flows; relative valuation compares its multiples with similar companies.

What drives a company's value?#

Its cash flow, the growth of that cash flow and the risk of achieving it.

Next, learn the most popular multiple in P/E and Forward P/E.