A stock market correction is inevitable every so often. But over the last three years, the pandemic and Russia’s war in Ukraine have engendered an enhanced state of volatility.
In fact, we’ve seen several corrections since 2019. These can be challenging, but they also create opportunity.
Stocks facing challenges
I’m currently faced with the very real possibility of entering my thirties with very little or no investments after some sizeable purchases, including a house.
But if everything goes to plan, I’ll have some capital to restart my investments in early 2023. So, in reality, the stock market correction might work in my favour.
After all, hundreds of UK stocks are currently trading at discounted prices versus this time last year. And this should provide me with the opportunity to snap up some cheap stocks while the market is depressed.
The idea that hundreds of UK stocks are down might come as a surprise to some — the FTSE 100 isn’t massively down on last year.
However, the index has been dragged upwards by surging resource and oil stocks. The reality is that many firms have faced challenges as inflation soared and amid the evolving recessionary environment.
Finding discounted shares
It’s easy to find stocks than are cheaper than they were a year ago. Housebuilders are among the most impacted. Some stocks in this sector are down 50%, or more.
However, just being cheaper than it was before shouldn’t indicate if a stock’s a good buy. This is where I have to do my own research.
A good place to start is by looking at simple metrics such as the price-to-earnings, price-to-sales, or EV-to-EBITDA ratios. However, there are many more. And by comparing these metrics among stocks in similar sectors, I can develop an idea as to whether a stock is cheap or not.
An even better way of valuing a stock would be to use the discounted cash flow model (DCF). DCF concerns a valuation method that estimates the value of an investment using its expected future cash flows.
Using DCF
To conduct a DCF analysis, an investor must make estimates about future cash flows over a given period — in theory the length of the investment. Each year’s predicted cash flow is then divided by one plus the ‘discount rate’. The discount rate is applied to the calculation because money earned in the future is less valuable than money earned today.
By adding the discounted cash flows for each year during our period together, we reach the net present value. This can then be divided by the number of shares. In turn, this give us an idea of how much each share should be worth.
But, naturally, this model isn’t perfect. And it’s based on me making several assumptions. Thankfully, if the maths gets too difficult, there are several online calculators to help me.
