How To Value A Stock

Historically, one of the most popular avenues of investment has been the purchase of corporate stock. Over the past century, US equities have supplied growth and capital appreciation to investors, averaging a 6% rate of return annually.^[1] Although purchasing and holding corporate stock seems a safe bet in the long run, identifying a "diamond in the rough" is a challenging endeavour.

Types Of Value

In order to find a stock suitable for investment, one must first determine an individual stock's value, or worth. There are two basic types of stock value: the market value of a stock and the stock's intrinsic value.

A stock's market value is simply the current price the marketplace sees fit to exchange one share of corporate stock for currency. Market price is straightforward, public and an undeniable representation of stock value. The open market establishes the current value for a share of stock, as a stock's price is the result of all interaction between market participants.

Identifying a stock's intrinsic value is a bit more complex, as it is often based upon opinion and open for debate. A stock's intrinsic value is defined as being its "actual" or "real" value. ^[2] Intrinsic value takes into account a company's intangible assets as well as its growth potential. Brand loyalty, copyrights, patents, projected future earnings and sector growth are all components of intrinsic value.

At the core of stock valuation is the notion that a company's current market price may differ from its intrinsic value. As the two diverge, a perceived investment opportunity arises. Quantifying intrinsic value is the underpinning of most methods of stock valuation, and the backbone of traditional fundamental analysis.

Stock Valuation: Fundamental Investment Analysis

Fundamental analysis attempts to identify a stock's intrinsic value through an examination of data included in corporate financial disclosures. Income statements, balance sheets and cash flow statements are evaluated in an attempt to identify the financial health of a company in addition to its growth potential.

Comparison is a crucial element to establishing a company's value relative to its peers. Ratios derived from the data included in corporate financial reports give investors and shareholders the tools necessary to measure what a company was, is and will be worth.

Income Statement Analysis

The income statement of a company identifies profits derived from business operations over a specific period of time.^[3] Commonly, an income statement uses line items such as gross profit, cost of goods sold, operating expense and tax liability to arrive at a company's net income.

A company's current stock price can be affected greatly by data included in the income statement. If market expectations are not satisfied by a company's earnings for a specific period, then stock price can suffer. If the income statement is well received by market participants, stock price can strengthen.

From the standpoint of intrinsic value, items on the income statement are interpreted in a myriad of different ways. While a net income figure can be less than desirable to the market, certain investors may place emphasis on other items included in the income statement. Robust revenue, reasonable expenses or a reduction in tax liabilities can boost the probability of future earnings and serve as the basis for investment.

Income statement-specific ratios are tools used to measure corporate profitability relative to a company's peers. Net profit margin, return on equity, return on assets and operating margin are a few ratios that are typically used to gauge a company's profitability and efficiency. Sustained profitability is widely viewed as the most important representation of corporate value and can act as a catalyst for appreciating stock value.

Balance Sheet Analysis

The purpose of a balance sheet is to provide the shareholders with an accurate picture of a company's liquidity. In order for a balance sheet to be valid, it must adhere to the following formula: Total Assets = Total Liabilities + Equity.^[4] The complexity of a balance sheet varies with the company and industry, but no matter the size or scope of a company, information regarding its assets and liabilities are disclosed to the public.
Several ratios are specific to the balance sheet, and relevant to measuring the ability of a company to pay its bills. The quick, current and debt-to-equity ratios are a few of the main ratios used to interpret balance sheet data.^[5]

Shortcomings rooted in a corporation's liquidity or solvency can give rise to concerns over a potential bankruptcy or stock dilution. Questions regarding a company's ability to conduct regular business operations can be devastating to stock price and projected future earnings.

In the event of a bankruptcy, corporate stock is largely worthless. Often, shareholders receive little or no compensation from the liquidation of corporate assets. When valuing a stock, it is imperative that a company's balance sheet be evaluated thoroughly; a corporate bankruptcy can be disastrous to an investor's portfolio.

Cash Flow Analysis

A statement of cash flows is used to examine a company's generation and use of cash on a periodic basis. Investors and shareholders use the statement of cash flows to identify the efficiency of corporate capital management.

Although not as commonly used for company valuation as the income statement or balance sheet, cash flow analysis provides insight into operations. Excess cash can be used by a company for investment in research and development, reduction of debt or the payment of periodic dividends to shareholders. Conversely, a deficit in cash flow can place strain on a company, with increased debt and hampered growth often being the result.

The ratios used to interpret a company's cash flow are the operating cash flow ratio, price to cash flow ratio and the cash flow margin ratio.^[6] Again, the ratios are an important component of corporate valuation because they afford the investor or shareholder the ability to compare performance.

At the end of the day, a company's health is related directly to the amount of revenue generated by business operations. Sub-par cash flows are a sign of waning business and often a precursor to financial distress.

Summary

It is important to remember that when one purchases a share of corporate stock, one has a claim to a portion of the profits made by that corporation. Strong companies generate profit and warrant a higher valuation, while weaker companies have the potential of rendering an investment worthless. Through the implementation of fundamental analysis on a company's financial reports, strong companies can be readily identified and more sound investment decisions can be made.

Past performance is not indicative of future results. Trading on margin carries a high level of risk and can result in losses that exceed deposited funds.

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