Valuation is crucial in stock investing. In the previous sections, we've introduced common valuation methods: the price-to-earnings (P/E) ratio, the price-to-book (P/B) ratio, and the price-to-sales (P/S) ratio. We also discussed the three dimensions of valuation assessment: the industry's average valuation, the company's historical valuation, and the company's growth rate.

However, valuation is more than that. In this section, we'll walk you through four factors affecting valuation.

1. Business model

Business models can play a crucial role in valuation. There's a lot about business models, and this section will mainly focus on how the life cycle of (or the frequency of demand for) a company's products and services impacts valuation.

First, suppose demands for a company's products or services are expected to be continuous or even perpetual, meaning a long product life cycle. In that case, it is good news for valuation. Conversely, intermittent demand curtails valuation.

For example, consumer products such as spirits and milk may always be in continuous demand and thus have a long product life cycle. In contrast, video games of various types that come thick and fast may have a shorter life cycle. Furthermore, demand for products like COVID-19 vaccines seems not sustainable in the long run.

Second,frequently-demanded products or services with stable revenue streams from individual customers will also be a plus for valuation. Again, if customers do not have a high demand for a product or service, the provider will have to find new customers, which will curtail valuation.

For example, some software companies adopt a subscription business model, charging customers for the services each year. The revenue is relatively stable, which is conducible for valuation. However some other companies' revenue models may be project-based, charging fees based on the number of projects. In this way, companies have to continue expanding their customer base. So their unstable income may affect valuation.

The same goes for the auto and real estate sectors. Most ordinary people can buy only one house in their entire life and a new car over many years, so mature real estate companies or automakers may not be highly-valued.

2. Profitability

Assume that there are two companies with a net profit of $1 billion in the past year, but one had an annual income of $5 billion and another $10 billion. The former got the same profit as the latter with only half the revenues since it had greater profitability.

To a certain extent, a company's profitability may represent its position in a particular industry.

Generally, if competition within a sector is intense, the company's gross margin for products or services may be low. Conversely, if a company is in a highly concentrated industry with a significant market share, its gross profit margin may be pretty high.

Also, companies with less competitive pressure may sell their products more efficiently. As a result, they don't have to shell out for marketing and thus have a higher net margin. On the other hand, companies with many competitors may face reduced net margins as they have to rely on large-scaled promotions to increase their market share.

Therefore, in many cases, companies can be overvalued for their more robust profitability, less pressure from the competition, and better prospects.

3. Cash flow

Cash flow is the lifeblood of a growing company. Many companies go bankrupt, not because of continued losses but disrupted cash flow.

A company's position in an industrial chain can affect its cash flow. A company with strong bargaining power over upstream suppliers can enjoy longer payment cycles and slower cash outflows. If a company has strong bargaining power over its downstream customers, it can collect loans more quickly, increasing cash inflows. In both cases, the company's overall operating cash flow is improved.

Therefore, companies with strong cash flow are more likely to thrive and occupy a strategic position on the industrial chain with a valuation premium.

4. Debt-to-asset ratio

Every company runs up debt. The most commonly used indicator to measure the level of debt is the debt-to-asset ratio. The formula is Debt-to-Asset Ratio = Total Debts / Total Assets.

A high debt-to-asset ratio may have three implications.

First, it may lead to higher repayment pressure. All liabilities, especially those with interest, have to be repaid. If loans are not repaid when due, they may disrupt cash flow or even cause bankruptcy.

Second, lower profit level. A company's interest-bearing liabilities, which require interest payments, generate expenses and affect net profit.

Third, slower business expansion. If a company with a high debt-to-asset ratio continues to finance its business expansion by borrowing money, the debt ratio will be driven up, making the company riskier. To ensure sound operation, the company may need to suspend business expansion.

Therefore, a high debt-to-asset ratio may have a negative impact on company's valuation.

In conclusion, the valuation of an enterprise is subject to many factors so that the assessment can be quite complex. To make a comprehensive assessment, we need to analyze a combination of many factors rather than just a few indicators. That's all for this section. In the next section, we'll introduce how to use the valuation methods we've learned.