Using Valuation Ratios and Cash Flow Models to Assess Stocks

# Answer by alexbougias (score 1)


# What is a robust method to determine if the stock's market price is below its intrinsic value and can be bought in a Fundamental analysis perspective?












It is a very common idea that Fundamental analysis looks at the intrinsic value of a stock, but if I were to look at the stock market right now, I just see the movement of the price of the stock, volume, crowd behavior, and etc. I know technical analysis can use these information to find entry points and all, but I was hoping to approach it in a Fundamental analysis approach.

When I do look at financial statements, I just see the balance sheets or income statements, but that's about how much I know about how the company is performing in a financial perspective because I do not work at that company. So how do I use these financial statements (or other references) to actually say that, for example, $23.43, the current market price, is most likely below its intrinsic value, and buying it will most likely earn me profits. People will most likely financial ratios to gauge the company, but how do you use them to decide? What are all the factors or ratios that you will look at the come to a decision?

Most people will just give their thoughts and open ended answers, but if possible, a clear and basic example on the matter, until a decision whether to buy or not has been made, is preferred. Because if it's all open ended, then I feel there is a lack of understanding and I feel like it is similar to gambling

## Answer by alexbougias (score 1)

https://quant.stackexchange.com/a/45450

You can construct some financial ratios, such as P/E Ratio or P/B.

### P/E Ratio

P/E Ratio stands for Price/Earnings. As Price you can use the market value of equity and for Earnings the Total Net Profit from firm's Income Statement. Equivalently, you can divide both measures with the outstanding shares. This way P/E Ratio stands for Stock Price/EPS.

An example: Suppose that XYZ Corporation belongs in the Utility Sector. The industry P/E Ratio equals 10. XYZ has a P/E Ratio of 30. Should we buy or sell XYZ Stock?

$P/E=30$, translates to "Investors are willing to pay 30\$ for each 1$ of XYZ earnings" Stock is overvalued compared to industry's P/E Ratio, as "Investors are willing to pay 10\$ for each 1\$ of industry earnings". XYZ is a growth stock, since other companies are traded at x10 P/E Multiple, and should be sold.

```
Rule of Thumb: P/E Ratio is Low compared to industry (Value stock) : Buy signal
               P/E Ratio is High compared to industry (Growth stock): Sell signal
```

### P/B Ratio

Stand for Price/Book Value. Market value of equity is divided by the Book value of equity(Total Shareholder's Equity, extracted from firm's balance sheet). Equivalently, you can divide both measures by the total shares outstanding. A high P/B ratio indicates expensive stock, since market value exceeds the book value. A low P/B ratio indicated a company with an "expensive" balance sheet.

```
Rule of Thumb: P/B Ratio is Low compared to industry: Buy signal
               P/B Ratio is High compared to industry: Sell signal
```

Source: http://www.stingyinvestor.com/SI/articles/MS1010b.shtml

Note that these discrimination rules refer to relationship among averages (not a deterministic rule). Also, note that these ratios are affected by accounting standards (how firm treats it's assets, revenues, expenses and so on) and informationally might be biased.

## Answer by phk31 (score 0)

https://quant.stackexchange.com/a/45449

According to the forefront of value investing professionals and stock picker (E.g. Howard Marks) technical analysis may be used as aid to determine timing a bit better but given one can assume stock prices to develop according to a random walk, using past graphing data to determine its future development is rather unlogical, at least according to theory.

Really what you seem to be asking is how to 'fairly' value a company. Simply, there is no one true value or correct method. You would do well to review corporate finance and the valuation metrics laid out there. The most fundamental analyses to value a company are: Discounted Cash Flow methods (based on dividends, FCFF, FCFE or other cash flows. Many models have been suggested over time). Furthermore, comparable company and transaction analysis (CCA & CTA). In the industry many use CCA and CTA as an initial valuation, as its quick and dirty. DCF's are based on rigorous assumptions and can vary greatly dependent on them but a DCF is in theory the most sound valuation method.