How do I know if a stock is 'cheap' or 'expensive'?

Investing with moomoo joined discussion · Jul 2, 2021 17:29

By Melody

How do I know if a stock is 'cheap' or 'expensive'?

Is it the amount I have to pay to buy a share of the stock?

If it is simple as that, then what does it mean when someone is saying a certain penny stock is expensive?

To solve these questions, we have to learn to perform valuation analysis on stocks.

By performing valuation analysis on stocks, we will be able to know if the stock is currently undervalued or overvalued using our valuation as a benchmark.

While the logic behind is very simple to understand, choosing the best valuation method and performing the valuation analysis gets a bit complicated.

When deciding which valuation method to use to value a stock for the first time, it's easy to become overwhelmed by the number of valuation techniques available to investors. There are valuation methods that are fairly straightforward, while others are more involved and complicated.

Is there a 'one size fits all' valuation method?

Unfortunately, there's no one method that's best suited for every situation. Each stock is different, and each industry or sector has unique characteristics that may require multiple valuation methods.

There are several methods for valuing a company or its stock, each with its own strengths and weaknesses.

When choosing a valuation method, make sure it is appropriate for the firm you're analyzing, and if more than one is suitable use both to arrive at a better estimate.

The two categories of valuation models:

Valuation methods typically fall into two main categories: absolute valuation and relative valuation.

Absolute Valuation

Absolute valuation models attempt to find the intrinsic or "true" value of an investment based only on fundamentals. Looking at fundamentals simply means you would only focus on such things as dividends, cash flow, and the growth rate for a single company—and not worry about any other companies. Valuation models that fall into this category include the dividend discount model, discounted cash flow model, residual income model, and asset-based model.

Relative Valuation

Relative valuation models, in contrast, operate by comparing the company in question to other similar companies. These methods involve calculating multiples and ratios, such as the price-to-earnings(P/E) ratio, and comparing them to the multiples of similar companies.

For example, if the P/E of a company is lower than the P/E of a comparable company, the original company might be considered undervalued. Typically, the relative valuation model is a lot easier and quicker to calculate than the absolute valuation model, which is why many investors and analysts begin their analysis with this model.

Keep an eye on moomoo courses to learn more about valuation methods!

Disclaimer: Moomoo Technologies Inc. is providing this content for information and educational use only. Read more