How to Determine What a Stock Is Worth

Investors often lean into valuation ratios to determine what a company’s stock is worth. Why? Such ratios are easy to calculate and easy to find.

5 Popular Valuation Ratios

Price/earnings ratio: A stock’s price divided by the stock’s earnings per share. This is the most commonly referred to stock valuation metric.

Price/book ratio: The market price of a company’s outstanding stock divided by the company’s book value. Book value is the total assets of a company less total liabilities, preferred stock, and intangible assets. Book value is often used when evaluating banks where book value is tangible capital or for distressed situations to determine valuation in a liquidation type scenario.

Price/cash flow ratio: A stock’s current price divided by the trailing 12-month operating cash flow per share. This is an indication of a company’s financial health.

Price/sales ratio: A company’s market capitalization divided by sales. The price/sales ratio represents the amount an investor is willing to pay for each dollar generated of revenue by a company’s operations. This ratio is often used for early-stage companies without earnings or companies whose earnings are negative.

Dividend yield: The dividends per share of a company over the trailing one-year period as a percentage of the current stock price.

Financial ratios such as these have their limitations, though. For starters, they rely on short-term historical data, which might not accurately reflect what’s ahead. They don’t account for nonfinancial factors, either, such as management quality, competitive positioning, and industry trends. And they don’t consider things like leverage, currency risk, and other factors that can affect a company’s long-term growth and profitability.

Determining a Stock’s Intrinsic Value: Morningstar’s Approach

Morningstar’s framework for valuing companies doesn’t rely on standard financial ratios. Instead, we believe that a company’s intrinsic worth—or its fair value—stems from the future cash flows it can generate. Specifically, the intrinsic value of a company is the present value of all the future free cash flow it will generate over its lifetime, discounted by its weighted average cost of capital.

How does Morningstar calculate a company’s fair value? Our approach is centered around carefully predicting the company’s future cash flows, based on primary research by our analysts. They use specific assumptions tailored to each industry and company to feed income statement, balance sheet, and capital investment assumptions into our standardized, proprietary discounted cash flow model.

We believe this detailed, long-term approach to estimating a stock’s value is more reliable than other valuation methods. By forecasting cash flows over several years and considering various scenarios, we can spot potential future trends and assess how well a company uses its capital. This approach also helps us focus on the most important long-term factors affecting a company’s value, rather than short-term market fluctuations that don’t reflect its true worth.

Plus, using a DCF-based approach to valuing a company is especially helpful for understanding cyclical companies, high-growth firms, or companies expected to lose money in the near future.

We don’t ignore multiples entirely, though: We use them as a secondary check against our DCF estimates. And we recognize that DCF models have their own challenges, such as relying on many estimated inputs. However, we believe that these issues are offset by our thorough analysis and focus on the long term.

Morningstar combines the financial forecasts of its analysts with a company’s Morningstar Economic Moat Rating to determine how long returns on invested capital are projected to exceed the firm’s cost of capital. Companies with wide moats are expected to earn excess returns on invested capital for at least the next 20 years, and narrow moat companies should generate excess ROIs for at least 10 years. If a no-moat company is generating excess returns today, we expect those returns would be eroded away by competitors. The size of a company’s moat affects our estimate of intrinsic value, as the longer a company can generate excess returns over time, the greater its valuation today.

This article includes updated content that originally appeared in Morningstar’s stock investing course, which was distributed by The Professional Education Institute.