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The Two Main Types of Quantitative Stock Analysis Described

Quantitative analysis for stocks means finding the value (or “valuation”) of the stock using numbers. There are two main types of quantitative valuation methods for stocks—relative and absolute valuation.

Both relative and absolute valuation metrics use numbers only, making them purely a quantitative analysis.

Both have already been defined, so we don’t have to reinvent the wheel on them.

And both can be used objectively, which is a major benefit of quantitative stock analysis. The only subjective parts of numbers-based valuation are the inputs, which for absolute valuation models can be estimated or projected instead of directly copied from historical data.

The difference between the relative absolute valuation methods of analysis are the following:

  1. Relative valuation is used to compare the value or pricing of companies to each other
  2. Absolute valuation attempts to find a specified intrinsic value of a stock

Let’s cover the important concepts behind relative and absolute valuation so that you can use either to analyze stocks with numbers.

Quantitative Method #1 – Relative Valuation

Relative valuation refers to all of the price-based metrics which are used to compare stocks to each other.

Typical relative valuation metrics include:

  • P/E, or Price to Earnings Ratio
  • P/FCF, or Price to Free Cash Flow Ratio
  • P/S, or Price to Sales Ratio
  • P/B, or Price to Book Ratio
  • Others…

Which relative valuation metric is used for a company generally depends on what industry the company is in. And the way each of these metrics are used is slightly different, but important to understand on a basic level.

P/E and P/S Ratios

The most broadest ratio is the P/E ratio, which allows investors to determine how expensive a stock is priced in the market compared to its earnings.

Investors will commonly compare a stock’s P/E ratio to its competitors, to its own historical P/E ratio, the market average’s P/E ratio, and the market’s average historical P/E ratio to get a sense on if a stock is relatively overvalued or undervalued at any given time.

But because there are many factors which go into Earnings, and also the value of a stock/company over time, investors rarely rely solely on a P/E ratio to determine value.

For industries in a young, high growth stage, the Price to Sales ratio is generally one of the main relative valuation metrics referred to. This is because companies that are young and in their high growth stages usually reinvest their cash flows and revenues back into the business—making those businesses unprofitable as they continue to scale.

Since you can’t use a P/E ratio when a company’s earnings are negative, the P/E ratio as a form of quantitative stock analysis is generally useless for high growth, early stage companies.

The Controversial P/B Ratio

The Price to Book ratio is commonly used in the financial industry for relative valuation purposes. This is because that for financials, equity on the balance sheet is basically their working capital (working capital is the short term investment needed for a company to earn revenues, companies can’t grow without it).

In other words, financial companies such as banks need a certain amount of cash on their balance sheets in order to grow; for banks, they take deposits and use this cash to make loans, and make profits on the spread between the deposit fees and the interest earned on the loans.

Because banks and other financials can’t grow profits without having this cash (or equity) as “working capital”, their level of equity determines their growth potential; that’s why the Price to Book is used (which compares price to “book value”, also known as “shareholder’s equity”) for these companies.

The P/B metric used to be a much more popular metric until the advent of the internet and the emergence of more new businesses models which don’t require “tangible assets” but rather can generate massive cash flows through “intangible assets”, such as software and technology-driven innovations.

Because intangible assets are often not recognized on company balance sheets, they don’t show up through the P/B Ratio, which looks only at the balance sheet.

Unless accounting standards change to accommodate the inclusion of most intangible assets on balance sheets, it’s likely that many newer business models will continue to be tough to evaluate using the P/B ratio—even if comparing one technology company to another.  

The P/FCF and EV/EBITDA Metrics

Both of these metrics are those typically used by more sophisticated investors or stock analysts. EV stands for Enterprise Value and is derived from a stock’s price (the “P” in all of these relative valuation ratios), and so its application works in a similar way to the other price-based relative valuation ratios.

Each of these metrics aren’t directly found on a company’s financial statements (generally), and must be calculated by adding financial statement line-items together.

For example,

  • FCF = generally calculated by taking Cash From Operations Minus Capital Expenditures
  • EBITDA = taking EBIT (from income statement) and adding back Depreciation & Amortization (in the cash flow statement)
  • EV = market capitalization (calculated from stock price) + Market value of debt – Cash

Each of these metrics calculate slightly different parts of a company’s financials, trying to give a clearer picture of some of the inconsistencies with standard accounting.

Free Cash Flow (FCF) is used instead of Earnings because it takes into consideration the real costs to grow for companies (such as investments in capital expenditures or working capital).

The actual cash situation of a company and its accounting for earnings (profits) don’t always line-up because various IRS and SEC requirements. FCF helps investors get to the truer cash profile for companies and avoid those that take massive capital investments to generate revenues (and profits).

EV/EBITDA is used to try and get a better “apples-to-apples” comparisons between companies.

Since EV takes company debt into consideration, it can be a more helpful comparison for investors wishing to include the leverage profile of a company into its valuation.

This is different than the P/S ratio for example, where a company could have great sales but be driving it through massive debt. A company might have a great P/S because of its large sales, which would be deceiving if the balance sheet was weak. EV/EBITDA potentially captures that risk by including the market value of debt in its Enterprise Value calculation.

Quantitative Method #2 – Absolute Valuation

The other most common quantitative method for stock analysis in finance and the stock market is absolute valuation.

And by far the most common absolute valuation method is called the DCF, or Discounted Cash Flow, valuation model.

The definition of a DCF valuation model is simple:

  • It is the present value of all future free cash flows

This might sound simple, but it’s a little more to unpack.

1—First, a DCF focuses on free cash flow because it represents all of the true cash that is available to business owners (shareholders) after all expenses and investments are paid off.

At the end of the day, it’s that free cash flow which makes any asset valuable.

What makes it interesting is that we don’t buy assets such as stocks for the cash flows we receive today necessarily, but rather for all of the cash flows we receive into the future. With great investments, those free cash flows could continue to generate indefinitely (or “into perpetuity”).

Those indefinite cash flows and (hopefully growing) future cash flows represent true value to the asset holder, and its what drives the valuation of a stock.

2—The next key part of this is the phrase “present value”. There’s several important ramifications of this phrase, but to try and summarize it down…

Cash flows today are generally worth more than cash flows tomorrow.

That is because you have two forces at play:

  1. Inflation
  2. Risk

The inflation part should be easy to conceptualize; our grandparents used to pay $0.15 for a burger and now we pay $2+.

Risk of future cash flows might be less intuitive, but think of this great proverb about it:

“A bird in the hand is worth two in the bush”.

In other words, cash today is more generally more valuable than cash in the future, particularly because cash in the future isn’t always guaranteed.

And because the definition of investing is putting money at risk in order to earn a return, cash flow in the future is worth less than cash today because it has that risk that is inherent with all investments.

The riskier the cash flows, the more the “present value” of cash today versus in the future.

The combination of present value and future free cash flows make up the foundation of every DCF model, whether doing a Free Cash Flow to Equity (FCFE) Model or Free Cash Flow to the Firm (FCFF).

The Two Components of the DCF Valuation Model

Calculating the present value of a company’s cash flows is done through what’s called the “discount rate”. You might also hear it referred to as the “cost of capital”, and it tries to encapsulate the risks of cash flow received in the future.

The future free cash flows are usually estimated by taking a company’s current cash flow generation (or potential generation in the near future) and estimating a growth rate for those cash flows.

Those two things might sound simple but there’s lots of detail to it; I highly recommend these two blog posts for an in-depth look at really learning how to do a DCF valuation model:

Hopefully you don’t get too bogged down if a DCF feels overwhelming—it really does just come down to the present value of future free cash flows at the end of the day.

That said, it does probably take several months of trying to learn the concept before it really takes.

It is worth the effort though.

Most companies on Wall Street are valued using some form of a DCF model, and it starts the foundation of what a company’s true intrinsic value is and where in the ballpark its stock should trade at. Even the great Warren Buffett admits that the intrinsic value of a stock is basically calculated by a DCF.

If you’re really wanting to learn about how to analyze a stock quantitatively, you should learn why and how a DCF influences the price of a stock. As estimated growth rates are adjusted (and interest rates move), both of these factor into the intrinsic value and can be observed in real-time with the proper understanding of the DCF valuation model.

Additional Books to Read About Quantitative Stock Analysis

There are many other aspects to quantitative analysis which can be implemented into any investor’s strategy to find great stocks through their research.

Some books I’ve come across not only talk about using relative valuation metrics to find stocks, but also how to manage a portfolio optimally when buying and selling these stocks in order to produce maximum gains.

Two I’d highly recommend as starting points include:

  • What Works on Wall Street by Jim O’Shaughnessy
  • The Acquirer’s Multiple by Tobias Carlisle

It’s very common for “quants” to turnover their portfolios very frequently when buying cheap stocks quantitatively.

For example, in both of the books above, a whole list of stocks are recommended to be purchased, with that list sold at the end of each year in order to buy a whole new entire list of cheap stocks (also called “annual rebalancing”).

This is a much different approach than finding a company’s intrinsic value through absolute valuation, which generally needs several years for those estimates to play out.

Books that are great for learning how to analyze a company with an absolute valuation (DCF) include:

  • The Little Book of Valuation by Aswath Damodaran
  • The Little Book of Sideways Markets by Vitaliy Katsenelson

Both strategies, absolute and relative valuation analysis, can be used over the long term to generate great stock market returns—however, oftentimes relative valuation methods involve high turnover and rebalancing while absolute valuation can tend to require long holding periods of stocks.

Not one strategy or the other is necessarily better, but both can serve an investor who likes the philosophy behind it and is disciplined to stick with that philosophy.