How to Use this Tool to Value a Stock
Here are the steps of how you might use a stock price calculator based on earnings
estimates and other financial data:
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Understanding the Basics of Stock Valuation
A stock price estimate is based on the fair value of a company's stock. Typically, it
uses a variety of metrics and assumptions about the company's earnings, growth,
interest rate environment, and market conditions.
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Gather Company Information and Earnings Data
Before using the tool, you'll need some key inputs:
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The Growth Stage of the Company: If the company is newly listed (IPO), a
start-up, or in a knowledge-and-technology-intensive (KTI) industry, it's
normally in a high-growth stage. Otherwise, it's in the mature stage, where
explosive revenue growth is less expected.
-
Earnings Per Share (EPS) Estimate: This represents the company's earnings
divided
by the number of outstanding shares. It's a key measure of profitability. You
can often find this in the company's financial reports
or analyst estimates. Taking Apple Inc. for example, you may find
analysts' estimates of earnings here. The analysts may have a
few future years' forecasts, but
the further the estimate, the less accurate it would be. Some analysts may also
be biased in their estimate, especially intended to be more optimistic, so you
should consider to adjust the
EPS estimate by year.
-
Earnings Growth Rate: The expected growth in EPS over the
future years after the manually EPS inputs. You might use historical growth
rates or analyst
projections for the company's future growth. The stock price is very sensitive
to this input. The mature-stage EPS growth can not be higher than the
discount rate; otherwise, the stock price will be an infinite number.
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Set the Discount Rate
This rate reflects the time value of money and the risk associated with investing
in the stock. A common approach is to use a discount rate that adds an equity
risk premium (market risk premium) to
the risk-free rate based on how risky you perceive the investment to be:
-
Risk-Free Rate (e.g., Treasury Yield): A rate typically based on
government bonds (considered a "safe" investment). The current rates are
available in
the table next to the input for your reference. 10-year Treasury yield is
commonly used in valuation practice.
-
Equity Risk Premium: An estimate of the return expected from the stock
market above the risk-free rate.
Typical equity risk premium is around 2% to 8%, affected by the
following factors:
- Current economic conditions: When the stock market is in a panic
situation or when investors' risk appetite is low (unwilling to take the
risk), the risk premium is higher. When the market is overheated or
investors' risk appetite is high (willing to take more risk), the risk
premium is lower.
- Sector-specific or company-specific risks: A company or its
sector with more volatile earnings would have a higher risk premium
You may also check the current
recommended U.S. risk-free rate and equity risk premium here.
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Generate Stock Fair Price Estimate
After inputting the data, the tool should generate an estimate of the stock's
intrinsic value. This is essentially what the stock should be worth based on the
inputs you provided (e.g., EPS, growth, and discount rate).
-
Compare the Estimated Value to the Current Market Price: This helps you
assess whether the stock is overvalued or undervalued.
- If the tool suggests the stock's fair value is $100, but the market
price is $80, it could indicate a buying opportunity.
- Conversely, if the fair value is $100 and the market price is $120, it
might be overvalued.
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Additional Price Sensitivity Analysis (Optional)
To further evaluate if you want to invest in this stock, here are some risks
you can test:
-
Earnings Surprise or Disappointment: This lets you
shock the EPS growth to see how sensitive the stock's value is
(e.g., what happens if growth slows down).
-
Change in Interest Rate: This lets you
shock the risk-free rate to see how sensitive the stock's value is. In general:
- When the interest rates rise, the higher discount rate leads to lower
stock
prices, due to less attractive future cash flows, higher borrowing costs
for
the company, and
shifting
investor preferences towards bonds.
- When the interest rates fall, the
lower discount rate leads to higher stock prices, due to more attractive
valuations, lower borrowing costs for the
company, and
increased risk
appetite for stocks.
This relationship is not fixed, and market dynamics can be influenced by a
wide range
of factors, but generally, Treasury yield is still a key determinant in
stock price behavior.
Based on the calculation results compared with the current market price and the risk of
price shocked, you can assess whether or not to buy, sell, or short-sell this stock.