Valuation

Introduction

What is valuation? Strap yourselves in, this is going to be a wild ride. Valuation is probably the most critical concept in all of investing, and unfortunately for us, it’s one of the most complex ones too. The definition of valuation is identifying the true value of a stock. What on earth does that mean? Let’s break it down.

The Value of a Stock

All stocks cost something. I’m sure we can all agree on that. That’s called the market price. However, the question we ask ourselves when understanding valuation is: Should the stock be at that price? Let’s introduce three terms to help us understand this. The fair value of a stock is the price that we think the stock should be at. This doesn’t have to match the market price. It is what we think the stock is worth based on the company’s financial status, a process called fundamental analysis. If the fair value happens to match the market price, we say the stock is at its true value. But what if the fair value doesn’t match the market price?

A Good Deal!

If the market price is lower than our estimated fair value, we say the stock is undervalued. What does this really mean? Well, if we think a stock should be worth $100 (aka, the fair value is $100), but it happens to be $80 right now, that means the stock is cheaper than it should be. You’re getting a good deal if you buy it! If a stock is cheap, chances are the price will go up in the future to match its fair value, earning you money. That’s good! But what about on the other side?

A Bad Deal

If the market price is higher than our estimated fair value, we say the stock is overvalued. Let’s run the same drill. If a stock should be worth $100 (the fair value is $100), but it happens to be $120 now, that means the stock is more expensive than it should be. If you buy it, you’re getting a bad deal, since chances are it will go down in the future to get closer to its fair value.

How to Value?

So far, I’ve been making all this sound so easy. All you have to do is buy undervalued stocks and avoid the overvalued ones, and you get rich! Unfortunately, it’s never that easy. The hard part is, of course, how do we value a stock? There are countless ways to do valuation. Some are incredibly easy, but these often aren’t that accurate. Others require advanced mathematical models that you learn in college. Let’s not talk about those, mostly because I don’t know anything about them.

The Basics

Probably the most common way to value a stock is with the P/E ratio, a metric that is so important I’ve dedicated an entire article to covering it. Check it out here. It’s important to note that the P/E ratio will not give you a fair value. It’s used to compare a stock with other stocks in the same industry to decide if a stock is cheap or expensive relative to similar companies. The P/E ratio is part of a whole other area of investing called fundamental analysis, which uses a massive arsenal of numbers and characteristics of companies to figure out if a stock is overvalued or undervalued. I have two whole videos in my free online course that cover fundamental analysis in detail, so check those out if you’re interested.

Conclusion

This article is long and convoluted as it is, so I’ll keep it brief. Valuation is a way to tell if a stock is a good or bad deal. It sounds easy enough, but it is very complicated. Fortunately, you only need to know the basics for your investing purposes. Unfortunately, these basics are still tough to digest. Valuation is probably the most important part of investing though, so it’s good to get familiar with it. Good luck!