Valuation is the process of determining the true value of a stock, beyond its market-listed price. It is an effort put in by the investor to dig beneath the demand-supply economics (and other market dynamics) that affect stock prices in the short term. After all, in the long term, companies with actual value are going to be the ones that deliver returns, right?

Investors have various methods of valuation at their disposal. It is best to choose one that appeals to your sense of logic. There are six types of valuation models and they fall under two categories.

Let us explore six popular methods of valuation so that you can choose one (or a combination) that works for you:

Valuation Models

The first category, that some investors refer to as absolute valuation, involves looking at a company in isolation and determining its potential based on certain parameters. There are two methods of absolute valuation, namely discounted cash flow and dividend discount.

The second category of valuation, referred to as relative valuation, uses comparison to determine the potential of a given stock. There are four models under this category, namely PE ratio, PEG ratio, Price/Book Ratio and Price/Sales ratio.

Let’s first look at relative valuation ratios as they are fairly simple to calculate.

Relative Valuation Methods

PE Ratio comparison

The price-to-earnings ratio of a company compares its stock price to its earnings during a given period. It indicates the amount of money an investor may be willing to pay for 1 share of the company for Re 1 of its earnings.

For example, Karnataka Bank has a P/E ratio of 3.96 as of 8 July, 2021, and SBI has a P/E of 18.57. This means that investors in Karnataka Bank pay ~Rs 4 for Re 1 of its earnings, and investors in SBI pay Rs 18 per Re 1 of its earnings.

PE Ratio = Market price of stocks / Earnings per share

There are two ways in which investors can use PE ratio. One, they can compare the PE ratio to that of a relevant benchmark index. Alternatively, they can compare the PE ratio of two companies operating in the same sector.

A higher PE means that investors have great expectations out of the company and are, therefore, willing to pay a higher price than its current earnings justify. A lower PE indicates that although the company’s earnings are good, the stock is trading at a lower price at the market. In this method, investors are looking to identify what is known as the intrinsic value of a company.

For example, let’s say an investor is considering buying the stocks of company X with a PE Ratio of 10. However, company Y and company Z from company X’s sector have a PE ratio of 14 and 21, respectively. The investor gets a sense that, at the moment, the stock price of company X is possibly justified and it may be worth the investment.

A low PE ratio generally indicates an undervalued stock whereas a high PE indicates an overvalued stock. This does not mean that investors must ignore stocks that fall in either brackets. It is just an indicator of how the stock is currently priced.

Some investors, including famously successful investor Warren Buffet and his mentor Benjamin Graham, use a strategy called Value Investing wherein they purchase stocks with a low PE ratio. Their belief is that if you buy stocks that are undervalued, you are buying at a discount. They believe an upward price correction will occur for undervalued stocks and the investor will be able to take in sizable earnings.

PEG ratio comparison

This model is the same as PE ratio, but it also brings the growth rate of earnings into the equation. Thus, while PE ratio may be criticized by naysayers for pegging value to only market price, PEG makes a projection by embalming the growth rate of earnings. A stock that may look “cheap” or “expensive” on just a PE ratio basis may not remain so when you consider how fast the earnings of a company are growing. Therefore, PEG ratio presents a more realistic picture of the value of a company.

PEG Ratio = (Share Price / Earnings per Share) / EPS Growth Rate

For example, let’s assume company X reported Rs 10 lakh earnings in a financial year. The share price at the time was Rs 10, and it had a total of 1.2 lakh outstanding shares. Its EPS witnessed a 1% growth over the last year and is projected to grow by 1.5% for the next year.

Therefore, its EPS for that financial year is Rs 8.3 (120000 / 100000).

Now, P/E ratio = 10 / 8.3 = 1.20

Hence, PEG ratio = 1.20 /1.5 = 0.8

A PEG ratio equal to 1 is achieved when the market rightly assesses the worth of the company. The share price is equal to its earnings. When the PEG ratio is less than 1, it is said to make ideal investment avenue led by its ‘undervalue’ assessment of the market. The opposite is true too – a PEG of more than 1 indicates the market is expecting a faster increase in earnings than earlier estimated, or that the stock is overvalued.

Price-to-book ratio comparison

In this model, the net value of all assets found on the company’s balance sheet is compared to its price to arrive at a valuation for the company.

PBV Ratio = Market price per share / Book Value per share

If PBV is low, it means that investors are not willing to pay a high price for the stock even though its assets justify a high price – this could be because of market sentiment, or some fundamental issue with the company. That said, this usually corresponds to an undervalued stock.

Similarly, a high PBV ratio generally indicates that the stock is trading at a premium despite the company’s net asset value not being justified. Such a company might be considered to be overvalued.

Price-to-sales ratio comparison:

As the name suggests, this ratio takes into consideration the company’s sales figures to arrive at a number that indicates its intrinsic value. The ratio assesses how much an investor must pay to buy one share of a company in relation to how much a single share generates in revenue for the company.

As with the other relative valuation techniques, a low price-to-sales ratio means that investors are not willing to pay a high price for the stock even though its sales justify a high price. This usually corresponds to an undevalued stock. Similarly, a high price-to-sales ratio generally corresponds to willingness of investors to pay a higher price in relation to the sales that the company is making.

PS Ratio  = Market Capitalization / Revenue

Just like with PE ratio, if an investor finds the stocks of company X with a PEG ratio (or a price to book ratio, or a price to sales ratio) that is higher than company Y or company Z that operate in the same sector, the investor should note that (at the moment) company X is trading at a higher stock price than is justified.

Absolute valuation models

Discounted Cash Flow

As some of you might already know, cash flow refers to the volume of money moving into and out of a business. To this model’s credit, it takes into consideration a company’s earnings as well as its expenditure to make predictions.

The formula used to calculate discounted cash flow is:

DCF = CFt ÷ (1+r)^t

where CFt refers to cash flow during the time period t;

r is a discount rate that is linked to the riskiness of the cash flow, and

t is the asset life value.

This method is used to analyse the potential of a company for 5 years to max 10 years, based on their cash flow numbers.

To this, investors will also add what is known as “terminal value” which attempts to calculate the value of the business for the remaining life of the business (over and above the period which the DCF formula covers).

The DCF model’s only downsides are it’s complexity, which might not suit amateur investors, and the fact that it cannot be used for companies whose cash flow is negative. However, negative cash flow in itself might be a red flag for some investors.

Dividend Discount

In this method, a company’s value is determined by deducting the amount of dividend it may pay out on a regular basis to its shareholders from its current value. The issue with this method – as you may have guessed – is that not all companies pay dividends, and even if they do so, they may not make payouts at regular intervals.

The argument in favour of the Dividend Discount model is that it calculates what the investor will actually get in hand during the course of his stock investment, considering dividends will be the only income the investor earns until he or she sells the stock.

Once the Dividend Discount is calculated, it can be compared with its current market price to assess is the stock is overvalued or undervalued.

Value of stock =  DpS / (Dr – DGr)

Where,

DpS is Dividend Per Share

Dr is Discount Rate, also called Cost of Equity

DGr is Expected Dividend Growth rate

This method is also far simpler than the DCF method – it traces dividends and the growth rate of these dividends to project a future growth rate. On the basis of this projected growth rate, the investor can decide if the stock is a worthy investment.

Conclusion

One or a combination of these valuation methods should help you to make more informed judgements on your investment. Beginner investors and those that don’t want to crunch numbers and play around with formulas might prefer relative valuation techniques. That said, not every company can be analysed correctly using every method. Use your discretion and perhaps double check a company’s potential using other means as well. Lastly, it is important for investors to understand that valuation is a tool that investors can use in order to make informed predictions and choices. It is not, however, a guarantee of earnings on the choices made based on these informed predictions. Investors should always consider their risk appetite before investing.