To pick the right stocks to invest in, you need to go off more than just good vibes. If you’re serious about investing in the stock market, understanding how to value stocks is a key skill. Stock valuation methods help you make investment decisions based on fact-based assessments instead of gut feelings, which in turn helps you steer clear of potentially mispriced stocks and improves your chances of long-term investment returns.
There are three main stock valuation methods: valuation multiples, comparable company analysis, and the dividend discount model.
What are valuation multiples?
Valuation multiples compare a company stock’s price to a specific financial metric, like the company’s earnings or sales. They show what investors are willing to pay for each dollar of the company’s revenue, profit, or net assets (i.e., its book value, or net worth on paper).
This approach offers a quick way to evaluate whether a stock is expensive or inexpensive compared to other companies in the same industry at a glance. That’s because it’s based on the theory that similar assets sell at similar prices.
Put into practice, valuation multiples are financial ratios. Equity multiples are the most commonly used valuation multiples, and they include ratios like:
Price-to-sales (P/S) ratio, which compares a company’s stock price to its sales.
Price-to-earnings (P/E) ratio, which compares a company’s stock price to how much it earns per share.
Price/earnings-to-growth (PEG) ratio, which takes the P/E ratio and divides it by the growth rate of a company’s earnings during a specific time period.
Price-to-book ratio (P/B) ratio, which compares a company’s stock price to what its net assets are worth on paper.
There are also enterprise value (EV) multiples, which look at the value of the entire company, not just its stock price. The most common EV multiples are:
EV/EBITDA (Earnings Before Interest Taxes Depreciation and Amortization), which compares the company’s total value to how much it earns from its core operations.
EV/Sales, which compares the company’s total value to the amount of revenue it brings in.
Pros of valuation multiples
Fairly easy to calculate, thanks to simple ratios that use easily accessible figures.
A solid first step in deciding which stocks might be worth closer consideration.
Reflect current market sentiment because they’re based on real-time stock prices rather than long-term forecasts.
Useful for when you want to see how a company stacks up against others in the same industry.
Cons of valuation multiples
Don’t take specific factors into consideration, like whether or not the company has strong competitive advantages over similar companies, reputable leadership, a unique business model, or strong growth prospects.
Also don’t account for how market sentiment is affected by other factors, such as government regulation and consumer trends.
Don’t represent the deeper, more intrinsic value of a company, since they only reflect what the market is willing to pay at the current moment.
Not that useful during market bubbles or crashes, when stock prices are less directly reflective of a company’s business performance.
What is comparable company analysis?
Comparable company analysis (also called CCA or comps analysis) is a way to assess a company’s value by comparing various metrics to the metrics of similar-sized companies within the same industry. By looking at the valuation multiples that comparable companies trade at, you can estimate what the stock you’re evaluating should be trading at.
Like valuation multiples, comps analysis relies on ratios, but it takes the evaluation of those ratios a step further. Here’s how it works:
Select five to 10 truly comparable companies. These are companies that are of a similar size, in the same sector, in the same geographic area, and that offer similar products or services.
Calculate key ratios for each of those comparable companies. These ratios usually include common valuation multiples.
Take those ratios and find the median for each. The median numbers provide a benchmark, representing what the “typical” company in the comp group is valued at.
Compare the ratios of the target company with the benchmarks to see how the company stacks up against its peers and to determine whether its stock might be priced in line with theirs, or over- or underpriced.
Pros of comps analysis
Accounts for industry-specific factors, since the comparisons are made using a truly comparable group of peer companies.
Relatively objective, since the analysis uses standardized ratios.
Doesn’t solely rely on the target company's own metrics.
Provides a deeper, more structured way to assess value than using valuation multiples alone.
Cons of comps analysis
Doesn’t work if the companies aren’t truly comparable, and it can be tricky to find enough that are truly comparable.
Not an effective way to evaluate companies with unique business models.
Can be a time-consuming way of valuing a stock, since you have to find data for multiple companies and then crunch the numbers.
Like valuation multiples, comps analyses can be skewed during market bubbles or crashes, when the whole sector could be over- or undervalued.
What is the dividend discount model?
The dividend discount model (DDM) is a way of determining what a stock is worth based on all future dividend payments (meaning what a shareholder would receive if they held onto the stock forever). DDM assumes that a stock’s dividends will grow at a predictable rate over time, which helps you estimate the value of all those future payments in today’s dollars.
To use the model, investors start by choosing a discount rate, which is the annual return they expect to earn for owning the stock. Then, they use a basic formula: next year’s expected dividend divided by the discount rate, minus the dividend’s expected growth rate.
Here’s an example:
A manufacturing company paid a $2.40 dividend this year.
Dividends are expected to grow at 3% per year.
Investors expect an 8% return for owning the stock (the discount rate).
Next year’s expected dividend is $2.47 ($2.40 multiplied by the expected growth rate).
By applying the DDM formula — which is $2.47 divided by the discount rate minus the expected growth rate — you can determine the stock’s estimated value today to be about $49.
What does that mean? If the stock is trading above, below, or roughly at that number, then you know it’s either overvalued, undervalued, or priced fairly.
Pros of DDM
Less influenced by market swings, because the valuation focuses on dividend payments and not short-term price movement.
Based on actual cash returns to investors, which makes the valuation more concrete.
Works well for evaluating income-focused investments, especially from stable, long-standing companies.
Helps you gauge the intrinsic value of a company, because it focuses on the long-term outlook of dividend payments, not a short-term forecast.
Cons of DDM
Only works for dividend-paying stocks; it’s not useful for companies that reinvest all their profits.
Assumes that dividends always grow at a steady rate, which isn’t always the case. Companies sometimes have to adjust their payouts.
Doesn’t account for potential price gains, because it only looks at dividends and doesn’t take into account how the stock itself might grow in value over time.
When to use each stock valuation method
Not every stock valuation method makes sense for every situation. Which method you choose to use should depend on what kind of company you’re trying to evaluate. This table can help you pick the right approach:
Company type | Best valuation method(s) | Why |
|---|---|---|
| Growth companies: Fast-growing companies that reinvest their profits in their business, and may have low or fluctuating earnings | Valuation multiples (especially revenue-based, using a P/S ratio or EV/Sales); comparable company analysis | Since these companies can report low or even negative earnings, revenue-based multiples (instead of earnings- or cash-flow-based multiples) and peer comparisons can give you a better sense of market value. |
| Mature/value companies: Established companies with steady profits and predictable cash flows | Valuation multiples; comparable company analysis; dividend discount model | Because these companies have stable earnings, all valuation approaches can be used. If you want to evaluate their intrinsic value, use DDM. |
| Cyclical companies: Companies whose performance rises and falls in line with the economic cycle | Valuation multiples (using normalized earnings, meaning average profits over multiple years instead of one unusually strong or weak year); comparable company analysis | These companies can experience big ups and downs. By using normalized figures and comparisons to truly similar companies, these two methods give a much more realistic valuation. |
How to combine approaches using the triangulation method
Stock valuation methods aren’t perfect. You could apply all three and come up with three very different results. That’s why many investors use something called triangulation, which means looking at a company’s value from multiple different angles and seeing where your valuation results align (or don’t).
By comparing results from valuation multiples, comparable company analysis, and DDM, you can spot inconsistencies and potential red flags. Vastly different results could mean a few different things:
The market has mispriced the stock (which could represent a potential investment opportunity).
Certain parts of the company’s business are shifting (something that one method may do a better job of identifying than another).
Deeper qualitative analysis is needed.
You used the wrong valuation method for the target company.
For example, let’s say you’ve crunched the numbers for a company using all three methods. Using valuation multiples and comps analysis, you’ve valued the company’s stock between $48 and $52 a share. But when you used DDM, your valuation fell to $35 per share.
A big gap between valuation multiples and comps, and DDM could signal that:
The company’s expenses are rising, or its earnings are slowing.
Maybe DDM wasn’t the right valuation method for this particular company (which could be the case if it doesn’t have a long history of stable dividend payments).
The market is more optimistic about the stock’s growth potential than what the current dividend suggests.
By highlighting the differences, triangulation can help you understand a company more fully, so you can make the most informed investment decision.
Stock valuation methods are tools that every investor needs to understand how to use. They keep your decisions rooted in something more solid than a feeling and help you spot when a stock might be mispriced. But it’s important to remember that they’re not flawless. Markets can act irrationally, assumptions can be wrong, and many important factors about a company or the market don’t show up in the numbers. Using stock valuation methods effectively means knowing how to select the most appropriate method for the situation, being realistic about their limits, questioning your conclusions, and combining different approaches to form a more holistic opinion.
