In stock market, it is very important for investors to know the intrinsic value of a stock, which allows them to buy the stock when its discounted or undervalued in order to gain profits. To figure out the intrinsic value of a stock, we would usually analyze the company’s financial performance as well as the fundamental factors.
The three major ways are: P/B, P/E, and free cash flow.
1. Price-to-book (P/B)
“Price” refers to the stock price while “Book” refers to book value which measures the value of the company’s assets. If this ratio is smaller than one, which means that the price is lower than the value of company’s assets, this stock is undervalued, suggesting that investors should buy it right now and sell it at a higher price.
2. Price-to-earnings (P/E)
“E” refers to EPS, earnings per share, which measures the net income generated by each share of a company’s common stock and that is to divide the net income by the weighted average number of common shares during the year.
This ratio reflects the company’s investment payoff period and shows the company’s track record for earnings. The smaller the ratio is, the shorter the payoff period is, and the more valuable the stock is. In this way, the investor could determine whether the stock is undervalued or not.
3. Free cash flow
Free cash flow is the remaining cash of one company’s revenue after paying the costs of expenditures (buying or upgrading equipment). In other words, free cash flow is the spare money of one company. If a company has free cash flow, it will use the extra money in the future to make investment, repay the loan, distribute dividends, etc.
Free cash flow can be used for discounted cash flow analysis. Basically, discounted cash flow analysis relies on the concept that future money is more valuable than present money. The sum of the present value of all future cash flows is the intrinsic value of the stock.