Stock valuation is critical for investing. If you buy a stock with a very low valuation, you are more likely to earn profits. On the contrary, you may suffer losses for buying an overvalued stock.

Valuation is an art. It varies by sector, and the valuation of a particular stock may change as time passes.

So, how to value a company? What valuation methods can we use? What are the factors that can affect valuation? And how to apply valuation theories?

To answer these questions, moomoo Learn now provides you with a course about valuation consisting of 5 sections. They are:

1. Why valuation matters

2. How to use the price-to-earnings (P/E) ratio for valuation

3. How to use the price-to-book (P/B) and price-to-sales (P/S) ratio for valuation

4. Other factors affecting valuation

5. Application of valuation methods

In the first section, we'll discuss why learning valuation is necessary. This section involves its definition, its importance, and common valuation methods.

1. What is valuation?

In stock investing, valuation means assessing a stock's intrinsic value.

Some novice investors may associate a stock's valuation with its price, thinking that the higher the stock price, the higher the valuation.

However, the share price only represents the market value of a share. Most listed companies have millions of shares outstanding. Market capitalization (market cap) is the current market price multiplied by the number of shares outstanding.

For example, As of the end of June 2022, Berkshire Hathaway Inc. Class A is priced at hundreds of thousands of dollars per share, but it only has about 1.5 million shares outstanding. So its market cap is less than $1 trillion. Apple's shares are hundreds of dollars, but the company has issued 16 billion shares, so the total market cap is in the trillions. (Source: moomoo app)

The market cap shows its current market value. Valuation assesses a stock's intrinsic value, which will give us an idea of whether its market cap is overvalued or undervalued to inform investment decisions.

2. Why is it necessary to learn valuation?

When to buy and when to sell are critical questions for every investor. Valuations can play a crucial role in decision-making.

When buying stocks, you may evaluate the intrinsic values of listed companies within the industry you're bullish on. If you identify a stock whose market cap is significantly lower than what you recognize as a reasonable valuation, you may consider it a potential buy.

On the other hand, When selling your holdings, you may consider selling the one whose price has risen beyond your assessment of a reasonable valuation or when the stock's fundamentals have deteriorated, causing the intrinsic value to decrease and fall below the current market value.

In addition, valuation can be a reference for risk assessment. For example, when the prices of most stocks are plunging in an economic recession, especially the case for those highly-valued stocks, you may consider reducing your holdings to hedge risks.

At this point, stocks with relatively lower valuations have a higher margin of safety so that they may fall less than average. In comparison, highly-valued stocks may plunge more. Therefore, it makes sense to sell stocks with higher valuations to manage the overall risk of your portfolio.

3. What are the valuation methods?

Generally, valuation methods fall into two categories: absolute and relative valuation models.

Absolute valuation models use discounted cash flow to value a company. Examples include the discounted cash flow model (DCF) and dividend discount model (DDM). When applying these models, we use the discount rate to calculate the present value of expected future cash flows. The company's intrinsic value equals the aggregate of the discounted cash flows.

As Warren Buffett said to his followers: "Intrinsic value is the discounted value of the cash that can be taken out of a business during its remaining life."

Although absolute valuation models seem scientific, they may not be easy to apply in practice. That's because a company's annual cash flow is uncertain, as no one knows if Apple could survive the next 20 or 200 years. Also, the discount rate can change with the interest rate environment and risk preference, leading to considerable deviations in the calculated intrinsic value. As Charlie Munger, Vice Chairman of Berkshire Hathaway, said jokingly, "I've never seen Warren calculate that thing."

Compared with the absolute valuation model, relative valuation models are more widely known and used. The most common relative valuation methods include the price-to-earnings (P/E) ratio, price-to-book (P/B) ratio, and price-to-sales (P/S) ratio.

Price-to-earnings (P/E) valuation is the most widely-used model for companies with stable earnings. The formula is P/E Ratio = Share Price / Earnings per Share, or: Total Market Cap / Net Income.

The price-to-book (P/B) ratio mainly applies to companies with less stable earnings. The formula is P/B ratio = Share Price / Net Assets per Share, or: Total Market Cap / Net Assets.

The price-to-sales (P/S) ratio is used for companies yet to generate profits. The formula is P/S = Share Price / Sales per Share, or: Total Market Cap / Operating Income.

We'll introduce these relative valuation methods in detail in the following sections.

We've discussed the definition of valuation, its importance, and specific valuation methods. Next, we'll walk you through the most commonly used valuation method: the P/E ratio.