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Before initiating a position or accumulating more shares of a stock, it is important to assess the return potential. One needs to determine whether the stock is reasonably valued, overvalued or undervalued. Analysts do this in order to set their target prices. Portfolio managers do this analysis in order to determine buy and sell decisions. And individual investors should do their own analysis.

In order to determine the upside potential of a stock, the first step is to calculate the stock’s intrinsic value. The next step is to compare the intrinsic value with the stock’s current share price. As investment guru Warren Buffett put it, “Over time, stock prices gravitate toward intrinsic value." If, for instance, your analysis reveals that a stock’s intrinsic value is $120 and the current share price is $100, that means the stock is currently undervalued and it may represent a buying opportunity depending on your risk tolerance, return expectations and time horizon.

There are various valuation methods that can be used to derive a fundamental value for a stock. Noted below are three common methodologies: multiplier models, the dividend discount model and the sum-of-the-parts approach.

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Multiplier models

Multiplier models are commonly used to calculate a stock’s intrinsic value. For companies that are profitable, the price-to-earnings (P/E) ratio is often used. This is calculated by taking the current share price and dividing it by the earnings per share. A stock’s P/E multiple can be compared with other stocks in the same industry as well as with the company’s historical trading range and its historical average P/E. Among the large cap dividend stocks, bank and rail stocks are typically valued using forward P/E multiples. Other frequently used price multiple models are price-to-sales, price-to-book and price-to-cash flow.

Alternatively, in lieu of the stock price in the numerator, EV, or enterprise value, can be used. This is particularly useful when one is comparing companies with diverse capital structures. That is, when there are major differences in how companies use debt and equity to fund their operations and growth. Ratios commonly used and useful in analyzing a company’s valuation are EV/EBITDA (enterprise value divided by earnings before interest, taxes, depreciation or amortization) and EV/sales.

Stocks across various sectors are valued using EV/EBITDA. Technology stocks such as Open Text Corp. (OTEX) and Kinaxis Inc. (KXS), auto parts manufacturers Magna International Inc. (MG) and Linamar Corp. (LNR), as well as industrials stocks Stantec Inc. (STN) and WSP Global Inc. (WSP), are commonly valued on an EV/EBITDA basis. Energy stocks are often valued using an EV/DACF (enterprise-value-to-debt-adjusted-cash-flow) multiple.

Dividend discount model

For companies that pay dividends, the dividend discount model is a useful tool where you discount the value of future dividends and the future value of the stock at the end of the holding period (also called the terminal value) back to their present values, and add these values together. We are simply calculating what future cash flows or dollar figures are valued at today.

To illustrate, let’s assume an investor wants to hold a dividend stock for one year, has a required rate of return of 10 per cent, expects to receive 50 cents in dividends and anticipates the share price will be $10 in one year. First, to compute the present value of the future dividend, you would take the expected dividend divided by one plus the required rate of return. In this case, the equation would be 0.50/(1.1), and you get 0.45. Then, to calculate the present value of the expected share price in one year, take $10 and divide by one plus the required rate of return, or 1.1, and you get $9.09. Adding these two values together, the present value is $9.54 (45 cents plus $9.09). You would then compare this value with the current share price to see whether the stock is undervalued, overvalued or fairly valued.

SOTP (sum of the parts)

When a company has several unique business segments, a sum-of-the-parts methodology best captures a stock’s intrinsic value by using multiple methods simultaneously. One business segment may be valued using a price-to-earnings multiple while another division may be valued using an EV/EBITDA multiple. An example is Canadian Tire Corp. Ltd. (CTC.A) where the company has three distinct segments: retail, financial services and its ownership in CT Real Estate Investment Trust, each valued using different methodologies.

Here’s the bottom line. Knowing how a stock is commonly valued by the Street and institutional investors is important to be aware of. Too many times, I have seen comments by readers stating that a stock is trading at a ridiculously high level on a P/E multiple basis, in many cases with technology stocks, when investors should be evaluating the stock using a different methodology and the valuation would appear more compelling. By doing so, investors are at times missing out on some great investment opportunities.

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Jennifer Dowty is Globe Investor’s in-house equities analyst. Prior to joining The Globe and Mail, she worked for approximately 18 years in the financial industry, including at Manulife Asset Management.

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