Investing 101

There are different ways to value an equity security - some are straightforward while others require more work. One can easily be overwhelmed by the number of valuation methods but you can split them into 2 categories: absolute valuation and relative valuation. 

## Absolute Valuation

Absolute valuation aims to calculate the “intrinsic value” of a company based on projections and assumptions about the future performance of a company. This method looks at company fundamentals, such as dividends, growth rate and cash flow, to determine the true value of a company. However, a company does not always trade around its intrinsic value due to factors like momentum and macroeconomics. For example, AliBaba, one of the world’s largest online commerce companies, is fundamentally valued at a much higher price than the share price it is currently trading at. This is because the company is facing pressure from the government and this causes uncertainty about the future performance of the company. 

### Methods:

Dividend discount model - the price of a stock is equal to the next year’s dividend divided by the difference between the cost of equity and constant growth rate. 

Discounted cash flow - calculates the sum of the present value of all expected future cash flows, discounted at the weighted average cost of capital to determine the enterprise value of a company and eventually its stock price. 

Residual income model - the price of a stock is equal to the present value of future residual flows discounted at the cost of equity. 

Asset-based model - calculates the net asset value of a company based on the difference between the market value of its assets and liabilities. 

## Relative Valuation

As the title says, these methods value a company based on the valuation of similar companies in the same industry. This involves calculating ratios and multiples for several companies and then comparing them to each other. An example of a ratio is the price-to-earnings ratio(P/E) which measures its current share price relative to the earnings per share (EPS). For example, Ford’s P/E ratio is 16.00 but General Motors P/E ratio is only 5.91. This indicates that General Motors, relative to Ford Motor Company, is undervalued. This method of comparing ratios is much quicker and easier than any of the absolute valuation methods. 

When analyzing an equity, the best way to start is by seeing the relative valuation of your company versus its comparables. If you want to take it step further, then use an absolute valuation method to estimate the intrinsic value and share price of your company. 

There are different ways to value an equity security - some are straightforward while others require more work.

Valuing Equity Securities

Stock and Equity

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Before you get into trading, you need to understand the basics. This includes concepts and frequently used terminology in the equities market. You can’t call yourself a true “trader” till you speak the lingo. 

**Beta** - measure of a stock’s volatility relative to the overall market. A large equity index, like the S&P 500, is used as a benchmark and given a Beta value of 1.0. Therefore the Beta value of a stock is a relative measure to the movement of the overall market. If a stock has a higher volatility than the overall market, its Beta value will be greater than 1. If the stock swings less than the market does, its Beta value will be less than 1. Stocks with a high Beta value carry higher risk, but also the potential for a higher return, and vice versa for stocks with a lower Beta value. 

**Shares outstanding** - refers to the total number of shares issued by a company when they went public, including restricted shares (shares that cannot be publicly traded). This value can change if the company chooses to repurchase shares or or sell additional shares. Additionally, if the company has issued any stock options, this number can change in the future too. 

**Volume** - refers to the number of shares or contracts traded for a specific security during market open hours. This measure is used in all the different markets for different asset classes. This is a good measure of an asset’s trading activity and hence liquidity during market hours. 

**Range** - market prices fluctuate throughout the day, month and year. One way to observe price volatility is through the range, either daily or 52 week range (price movement over the last year). The range is calculated for different horizons by taking that specific horizon’s high minus the low. The low price is called the support price and the high price is called the resistance level because if either price is hit, this will cause a large move in the price, down or up. One type of investing (range-bound trading) focuses on trading a security between a defined range over time. 

**Earnings date** - scheduled date for the company to announce quarterly earnings. The markets react based on if earnings expectations will be met, beat or missed. 

Equity Due Diligence

Valuing Equity Securities