Common valuation mistakes made by both new investors and professionals

Stock valuation is often considered to be something a job should be done by professions. The truth is any investor would need a certain level of valuation skill to do their own valuation.

The simplicity of the multiple valuation approach is both an advantage and a disadvantage. Although this method allows investors to calculate an estimated stock price quickly, it also introduces the problem of simplifying complicated information into just a single value or a series of values, which ignores other factors that affect the company’s intrinsic value.

Investors should apply different valuation indicators when valuing different industries to determine appropriate target prices for the invested companies.

There are three principal valuation methods, being:

Some valuation methods would be more appropriate for certain kinds of businesses or industries than others. For example, a market-based valuation method such as theCapitalization of Earnings method assumes that the business would maintain a stable profitability and growth rate. On the other hand, discounted cash flow method allows more customized assumptions in expected income, as it involves calculating the net present value (NPV) of future cash flows.

Earnings before interest, taxation, depreciation, and amortization (EBITDA) is generally the most critical number upon which a market-based valuation will be predicated. However, to generate a reliable historical and forecast EBITDA, it must be normalized.

‘Normalization’ is the process of removing all ‘extraordinary’ or one-time-only transactions which are not an ordinary and recurring transaction of the business, such as government rebates and grants, sale of assets and expenditures such as Research & Development (R&D), Business Development, or other one-off outgoings such as legal settlements, etc.

If a company has experienced recently an upswing in its performance, in valuation many investors might hope for the company can maintain its current growth rate. Therefore, the estimation would generate an unrealistic result.

To support the estimation result of your company valuation, your theory must contain a secondary valuation of the business to provide some credibility to the primary valuation.

That could be achieved with a situation analysis to estimate the company when runs into an unfavorable situation, or you could use a sensitivity analysis, which is simple testing what if the growth rate or WACC you use in your model has changed by a percentage. How much would the stock price be influenced by that percentage difference?

In summary, it’s hard for individual investors to conduct their valuation estimation since the complexity of the whole process. However, if you are considering investing in stock rather than taking the advantage of short-term movement, but investing for a longer time. Any value investors would investigate the company and plan for their investment. So that you would not just leave the market easily when the company you invested in is experiencing a hard time. With a clear target price, it would help investors especially individual investors to stay rational when they are experiencing a volatile market.