2 Quick Valuation Factors to Understand Before Buying Stocks

Before buying shares of any company, we may want to put an estimated value on the company’s businesses. By doing so, we may come closer to figuring out if we’re buying at a good price.

I have written about why valuation is important and how valuation is important. So, let’s move on to two major ways you can think about valuation.

Relative valuation

As its name suggests, relative valuation relies on a comparison with something (another reference) to derive a value.

This form of valuation can be fairly similar to how a property would be valued. For example, if two HDB units are relatively in similar condition and have the same floor size, then the unit with the better location may command a premium over the other.

Point is, there should be a reference to compare.

For shares, we may use references like the price to earnings (PE) ratio. To illustrate, on 11 February 2015, my Foolish colleague Ser Jing pointed out that land transport giant ComfortDelgro Corporation Limited (SGX: C52) had carried a trailing PE ratio of 23.6 at a share price of S$3.09. This PE ratio by itself does not tell us much about the value of the company.

However, if you had compared that with ComfortDelGro’s historical PE ranges, you may start to think that shares of the company are trading at a higher level compared to its past. The comparison can be seen in the graph below produced by Ser Jing:

ComfortDelGro's historical PE ratios from Jan 2005 to Feb 2015

Source: S&P Capital IQ

Absolute valuation

On the other hand, absolute valuation is based on elements such as a firm’s profits, cash flows, or net assets and less on comparison with a reference point.

An example of absolute valuation could be the discounted cash flow (DCF) model that my colleague Ser Jing had shared sometime back on test and vehicle inspection firm, Vicom Limited (SGX: V01).

In the Vicom example, the process of valuing the company relied on summing up all the estimated future free cash flows that it can produce, and then discounting the entire sum back to the present day with a selected discount rate.

Compared to the relative valuation approach, the absolute valuation approach (DCF, in this case) does not rely on a comparison with another reference.

Foolish takeaway

Regardless of your choice in valuation tools, the most important thing may be to understand the underlying assumptions that you are making in order to derive a value for a company.

This may start with understanding whether your approach is an absolute valuation approach or a relative valuation approach. There are many more factors to consider in investing beyond just whether you should use a relative or absolute valuation approach, but these might be the first two factors to start off with.

Stay tuned for more on valuing companies.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong owns shares in Vicom.