Have you ever wanted to buy or sell a stock but didn’t know if it was a good deal or not? Stock valuation is the process that helps investors determine whether a stock is overpriced or underpriced.
By learning the stock valuation with examples, you can distinguish between valuable investments and overpriced ones.
Let us begin!
What is Stock Valuation?
Stock valuation is the process of estimating the fair value of a company or its shares. You can do that on the basis of various factors such as growth, earnings, assets, liabilities, risk, and market conditions. By knowing the stock valuation methods, you can decide whether it is worth buying, selling, or holding. This way, you can avoid overpaying or underestimating a potential investment.
An overvalued stock is usually one that trades at a price higher than its intrinsic value. On the other hand, an undervalued stock is one that trades at a price lower than the share’s intrinsic value.
• Market price is the current value of a stock as determined by the supply and demand of buyers and sellers in the market.
• Intrinsic value is the estimated worth of a stock based on its fundamentals, such as dividends, cash flow, growth, risk and earnings.
Share Valuation Methods
There are two main types of stock valuation methods- relative and absolute.
Relative valuation methods compare the value of a stock to the value of similar stocks in the same industry or market. Absolute valuation methods try to find the true or intrinsic value of a stock based on its own fundamentals, such as earnings, cash flow, and growth.
Relative Valuation Methods
This stock valuation method is based on the idea that the value of a stock is determined by the market forces of supply and demand. It also works on the principle that similar stocks should have similar prices.
These methods involve calculating multiples and ratios. It includes:
- Price-to-earnings (P/E) ratio
- Price-to-book (P/B) ratio
- Price-to-sales (P/S) ratio
- Price-to-cash flow (P/CF) ratio, and comparing them to the multiples of comparable companies or the industry average.
Let us understand each stock valuation method in detail:-
PE Ratio – Price to Earnings Ratio
The PE Ratio, or Price to Earnings Ratio, shows how much you’re paying for a company’s stock compared to its earnings per share (EPS). You can calculate it using earnings from different timeframes, but usually, people use the earnings from the past 12 months. It’s also called the earnings multiple or price multiple.
Price-to-Book (P/B) Ratio
The Price-to-Book (P/B) Ratio tells you the connection between a company’s total market value (market cap) and the book value of its equity. In simpler terms, it relates the company’s overall worth in the stock market to the actual value of its assets.
Price-to-Cash Flow Ratio
The Price-to-Cash Flow (P/CF) Ratio is a way to figure out how much a stock is worth compared to its cash flow per share. Cash flow includes real money coming in and can help account for things like non-cash expenses. This ratio is especially useful for valuing stocks with positive cash flow but not necessarily making a profit because of non-cash charges.
Price-to-Sales (P/S) Ratio
The Price-to-Sales (P/S) Ratio is a measure that compares a company’s stock price to its total revenues. It’s a way to see the market’s opinion on the worth of a company’s sales or revenues.
Relative valuation methods are easy, as they use readily available market data.
However, they also have some limitations, such as:
• They assume that the market is efficient and that the prices of similar stocks reflect their true value.
• They may not account for the differences in the quality, growth, risk, etc.
• They may not capture the future potential or unique characteristics of a company or its industry.
Absolute Valuation Methods
Absolute valuation methods are based on the idea that the value of a stock is determined by its future cash flows, dividends, earnings, etc.
These methods involve projecting the future performance of a company or its industry and applying a discount rate that reflects the risk and opportunity cost of investing in the stock.
Some of the most popular absolute valuation methods are:
Discounted Cash Flow (DCF) Method
This method estimates the stock value by projecting the free cash flow (FCF) of a company for a certain period and then discounting it to the present value using WACC-a weighted average cost of capital or a required rate of return. The FCF is the cash flow that a company generates after paying for its operating expenses and capital expenditures. The WACC is the average cost of financing a company’s assets, which includes both debt and equity. The required rate of return is the minimum return that an investor anticipates to earn from investing in the stock.
The DCF method is widely used and accepted. This is because it is based on the fundamental principle of valuation: the value of an asset is equal to the present value of its future cash flows.
However, it also has some limitations, such as:
• It requires a lot of assumptions and estimates, such as the FCF, the WACC, the growth rate, and the terminal value. It may be difficult to obtain or may vary significantly over time.
• It is sensitive to changes in the inputs, especially the discount rate and the terminal value, which can have a large impact on the final value.
• It may not capture the intangible value or the strategic value of a company or its industry.
Dividend Discount Model (DDM) Method
This method estimates the value of a stock by projecting the dividends that a company will pay to its shareholders in the future and then discounting them to the present value using a required rate of return or a cost of equity.
- The dividends are the cash payments that a company distributes to its shareholders from its earnings.
- The required rate of return is the minimum return that an investor expects to earn from investing in the stock.
- The cost of equity is the return that an investor requires to invest in the equity of a company.
The DDM method is simple and intuitive, as it is based on the idea that the value of a stock is equal to the present value of its future dividends.
However, it also has some limitations, such as:
• It only applies to companies that pay regular and stable dividends, which may not be the case for many growth-oriented or non-dividend-paying companies.
• It assumes that the dividends grow at a constant rate, which may not reflect the reality of the business cycle or the industry dynamics.
• It may not capture the value of the retained earnings or the reinvestment opportunities of a company.
Comparables Model
This is one of the widely used share valuation methods. It actually represents a versatile approach when other valuation methods are challenging or time-consuming. As per this, instead of determining an intrinsic value for a stock, this model compares the stock’s price multiples to a benchmark to assess if it’s relatively undervalued or overvalued.
You can use this model in various situations because it considers multiple ratios like price-to-book (P/B), price-to-earnings (P/E), price-to-sales (P/S), and more. Among these, the P/E ratio is commonly used as it focuses on a company’s earnings, a key factor in investment value.
When using the P/E multiple for comparison, you must ensure the company is publicly traded to have both stock price and earnings data.
Additionally, the company should have positive earnings, as a comparison with a negative P/E would be meaningless.
Stock Valuation Methods with Examples
Here’s a table explaining the stock valuation methods with examples:
| Valuation Method | Purpose | Working | Example |
| Price-to-Earnings (P/E) Ratio | This method compares the stock price to the company’s earnings. | The P/E ratio is calculated by dividing the stock price by the company’s earnings per share (EPS). | If a stock is priced at ₹200 and the company’s EPS is ₹10, the P/E ratio is 200/10 = 20. A higher P/E suggests the stock is expensive, while a lower P/E suggests it’s cheaper. |
| Price-to-Book (P/B) Ratio | This method compares the stock price to the company’s book value (assets minus liabilities). | The P/B ratio is calculated by dividing the stock price by the book value per share (BVS). | If a stock’s price is ₹150 and its BVS is ₹100, the P/B ratio is 150/100 = 1.5. A P/B ratio less than 1 may indicate the stock is undervalued. |
| Dividend Discount Model (DDM) | This share valuation method is used for companies that regularly pay dividends. It values the stock based on the present value of expected future dividends. | DDM is calculated by dividing the expected dividends by the difference between the required rate of return and the growth rate. | If a company pays ₹5 in dividends and its expected dividend growth rate is 5%, with a required rate of return of 10%, the stock value would be ₹5 / (10% – 5%) = ₹100. |
| Discounted Cash Flow (DCF) | This method values a stock by estimating the company’s future cash flows and discounting them back to the present value. | DCF calculates the future cash flows a company will generate and adjusts them to today’s value. | If a company is expected to generate ₹50 crore in cash flows every year for the next 5 years and the discount rate is 8%, the present value is calculated by discounting those cash flows. |
These methods help you understand the value of a stock, making it easier to decide whether it’s a good investment for you or not.
Some Common Myths About Stock Valuation
Myth 1: Valuation Should Be Accurate
Fact 1: Valuing a stock isn’t like a precise calculation. It’s more of an estimate based on various factors like earnings and growth. It’s not exact because it depends on assumptions and projections, which can vary.
Instead of aiming for a single exact value, it’s better to consider a range of values to account for the uncertainty in valuation.
Myth 2: The More Complex the Model, the More Accurate the Result
Fact 2: Don’t think that a complicated valuation model is always better. Sometimes, a simple model is better because it’s clearer and more robust.
Complex models might have more chances of error due to the increased number of assumptions and calculations. The key is to use a model that fits the purpose and context of the valuation.
Myth 3: Low Ratios Always Mean Cheap Stocks
Fact 3: Ratios like P/E, P/B, P/S, or P/CF compare a stock’s price to financial metrics. However, low ratios don’t always mean a good deal. They might indicate undervaluation, but they could also mean the company has low performance or prospects. Similarly, high ratios might suggest overvaluation, but they could also mean a high-performing company.
Myth 4: Stock Valuation Doesn’t Matter Because Markets Decide the Prices
Fact 4: While market prices are influenced by various factors, they tend to align with a stock’s true value in the long run. For long-term investors, valuation of stocks is crucial. It helps identify mispriced stocks and take advantage of market inefficiencies.
Myth 5: Valuation Is Objective Because It’s Quantitative
Fact 5: Valuation is not purely objective. It involves subjective choices and judgments, like selecting the valuation method and interpreting results.
Different analysts may use different methods and assumptions, leading to different values for the same stock. Valuation is not just about numbers; it requires logical reasoning and evidence.
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Importance of Stock Valuation for Traders and Investors
The valuation of shares helps you identify trading opportunities based on the distinction between the market price and the intrinsic value of a share. Traders can use various share valuation methods to estimate the fair value of a share and compare it with its current market price.
- If the market price is lower than the fair value, the share is undervalued and can be bought for a profit.
- If the market price is higher than the fair value, the share is overvalued and can be sold for a profit.
Valuation of shares can also help traders assess the risk and return potential of a share and, in strategic portfolio diversification.
On the flip side, valuation of a stock is also important for the company. It helps in strategic planning, capital financing, mergers and acquisitions, and tax assessments. For example, a company may use stock valuation to decide whether to invest in a new project, raise funds from investors, acquire another company, or pay taxes on its assets.
Conclusion
Stock valuation is an essential tool for making smart investment decisions. It helps you understand whether a stock is fairly priced, overpriced, or undervalued. By using methods like P/E ratio, P/B ratio, DDM, and DCF, you can evaluate a company’s true worth. Ultimately, learning stock valuation helps protect your investments and maximize returns.
Valuation of Stock: FAQs
Stock valuation is calculated by analyzing a company’s financial data using different methods like P/E ratio, P/B ratio, and DCF. These methods help determine if the stock is overvalued or undervalued.
To perform a stock valuation, you compare a company’s stock price to its earnings, book value, or future cash flows. This helps you understand the company’s worth and whether the stock is a good investment.
The valuation method of a stock involves calculating key ratios and metrics such as the P/E ratio, P/B ratio, or using models like DDM and DCF to estimate the stock’s true value.
The top 3 stock valuation methods are the Price-to-Earnings (P/E) ratio, Price-to-Book (P/B) ratio, and Discounted Cash Flow (DCF) analysis.
Stock value is the estimated worth of a stock based on its fundamentals, such as earnings, dividends, cash flow, growth, and risk. Stock value can be different from the current market price of the stock.
Stock valuation is important because it can help investors identify whether a stock is overvalued, undervalued, or fairly priced. This way, you can make better decisions about buying or selling the stock.
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Disclaimer: Investments in the securities market are subject to market risks; read all the related documents carefully before investing.