BAJAJ BROKING
September 19, 2024
4 mins read
Stock valuation helps us assess the true or intrinsic value of companies. Hence, it’s extremely important for all kinds of investors. There are several methods of stock valuation, like discounted cash flow (DCF) method, dividend discount model (DDM), price-to-earnings (P/E) multiple, etc.
It’s important to appreciate that these methods are not applicable for all kinds of companies. The most essential thing is to know which method to use and when. For example, the DDM approach is applicable only if a company is paying dividends regularly and its dividend payouts are increasing at a stable rate.
Hence, it’s important to apply discretion when using these methods.
If you are new to the stock market, you might have wondered what stock valuation is. In simple words, it means what the actual worth of a company is. Suppose you want to buy a share in a company, how will you decide whether to buy it or not?
For that, you’ll have to find its value. It is this process of finding a stock’s true or intrinsic value, which is known as stock valuation. Now that you have learnt the meaning of stock valuation, let’s delve deeper into this topic.
When we attempt to find the value of a company’s stock, it’s understood that we are performing stock valuation. At any point in time, we know the market price of all the publicly listed stocks. But how do we decide whether to buy or sell them?
For this purpose, investors employ various techniques to find the true or intrinsic value of stocks. If the value thus found is less than the market price, they buy that stock. However, if the value they have found is more than the market price of a stock, they sell it.
Let’s discuss a few popular methods of stock valuation.
This method falls in the category of absolute valuation. It assumes that the value of a company is equal to the present value of its dividend payouts in the future. It’s advisable only for those companies that pay dividends regularly and that show stable growth in their dividends.
This method is also a variation of absolute valuation. It assumes that a company’s value can be determined by first estimating its free cash flows in the future and then discounting them to find their present value.
This is a relative valuation method. Here, we find a ratio of a company’s price per share to its earnings per share. This shows us how much we are willing to pay for every rupee of profit a company generates. Then, we compare the P/E of a company with that of its closest rivals. If its P/E is lesser than that of its rivals, it’s a signal that we can buy it. If its P/E is higher, it shows that we can sell it.
The right valuation method for a company depends upon the context and the nature of the company. For example, the dividend discount model works well when a company pays dividends regularly and its dividend payout is growing at a stable rate. Similarly, the DCF method works well when a company has consistently generated free cash flows and is expected to do so in the future. Besides, its free cash flows are expected to grow at a stable rate.
You may be wondering why these conditions are necessary for these models to work. For the DDM model, we need to estimate how much dividends a company will pay. We can do so only based on its past record. If it has paid dividends regularly in the past and its dividends grew at a stable rate, it becomes easier to predict future dividends.
Similarly, if a company has generated free cash flows regularly in the past and such cash flows grew at a stable rate, it becomes easier to predict them in the future. Hence, these methods become applicable.
Now, let’s discuss when we can use the P/E method. For this, we first need a company’s stock price, which can be available only if it's listed publicly. Then, we need its earnings per share. Suppose a company is making losses, we can’t use this method because its P/E multiple will be negative, which is of no use. So, a company should be making profits. Besides, its net profit in the last few years should not have been too volatile because that will not provide a realistic picture of its profit-generating capacity.
Additional Read: What is a Remisier
Comparable analysis is a commonly used approach in stock valuation where an investor compares the financial ratios of similar companies in the same sector. This comparison provides insight into how a particular stock is priced in relation to its competitors. The metrics considered often include earnings, book value, revenue, and cash flows.
By using comparable data, an investor can assess the fair value range of a stock under review. For instance, if a stock has a lower Price-to-Earnings ratio than its peers, it may be considered undervalued, assuming other factors are consistent. However, one must ensure that the comparison is made among companies with similar scale and financial structure.
The Price-to-Earnings (P/E) ratio is a widely followed metric that helps investors understand how much the market is willing to pay for a company's earnings per share. It is calculated by dividing the current market price of a stock by its earnings per share (EPS). This ratio helps assess whether a stock is priced reasonably in relation to its earnings potential.
A high P/E ratio may indicate strong growth expectations, while a low P/E could signal undervaluation or a weaker growth outlook. However, the P/E should be evaluated within the context of the industry average. It is meaningful when used for comparing companies with similar operations, profit margins, and capital structures.
There is no fixed number that defines a “good” P/E ratio, as it depends on the industry and the company's growth prospects. In fast-growing sectors, a higher P/E may be considered normal, while in stable industries, a moderate ratio might be more appropriate. Comparing a company’s P/E with its historical average and that of its peers can offer clarity.
Investors also consider the forward P/E, which uses projected earnings, to evaluate whether future growth is already priced in. A balanced P/E ratio that aligns with both current performance and future outlook may be preferable. It is also important to check if the earnings used in the calculation are sustainable and not based on one-time gains.
A stock may appear undervalued based on traditional valuation metrics, but that does not always mean it is a good investment. This situation is often referred to as a value trap. It occurs when a stock is cheap for valid reasons such as declining earnings, weak management, or a troubled business model. Investors should conduct a comprehensive financial and qualitative analysis before making decisions based solely on a low valuation.
It’s not difficult to learn what stock valuation is or how to use various approaches. The trick is to understand and appreciate which method can be used for which company. That comes with experience and practice.
If you have just opened your demat account and are beginning to analyse companies to find their valuation, you should bear in mind that typically we use more than one method to find a company’s value. In other words, you can’t rely on just one method for stock valuation. Therefore, you should learn all the most prominent methods thoroughly and get a grip on when these methods should be used. After that, you’ll be able to use them like a seasoned investor.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.
This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.
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When we try to find the true or intrinsic value of a stock, it’s called stock valuation. It’s important because it helps us compare the true value of a stock with its market price. Based on that, we can decide to buy or sell it.
There are two types of stock valuation: absolute valuation and relative valuation. Under absolute valuation, we find the true value of a company without comparing with other companies. Under relative valuation, we compare certain multiples across companies to make a decision.
Under absolute valuation, the two prominent methods are: Dividend Discount Model and Discounted Cash Flow Model. Under relative valuation, the most prominent method is the Price-to-Earnings (P/E) multiple.
For this method, first, we need to estimate the free cash flows of a company in the future. Then, we have to discount them by the cost of capital of the company.
The ratio of a company’s price per share to earnings per share is known as the P/E ratio. When a company’s P/E ratio is higher than that of its rivals, it means we should sell its stock, and vice versa.
Under the CCA method, we compare the valuation of a company with that of comparable listed companies from the same industry. Under the PTA method, we compare a company’s valuation with that of those companies, which were sold in the past. If while valuing a company, we are finding it difficult to find a comparable company, then we can use the PTA method.
The quality of the performance data of a company (free cash flows, earnings, or dividends) can affect the accuracy of its valuation. For example, if a company’s earnings are fluctuating a lot across the years, it’s unlikely that we will find its true valuation by using its earnings. The other factor is how good our assumptions are.
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