Investing in the stock market requires prudence and picking the right stocks with a long-term investment perspective is crucial .This means, before investing in a business it is important to check several aspects about the financial health and future prospects of the company as they have a bearing on the profitability of your investment. This is where the concept of valuation comes into the picture. 

Valuation is the technique to determine the true worth of the stock after taking into account several parameters and then understand if the company is overvalued , undervalued or at par.  Let’s see how to do a valuation analysis of a company to assess its viability as an investment option. 

Methods Of Valuation Of A Company

Listed below, are the broad methods by which, valuation of a company can be done :- 

Income Approach  

The income approach of valuation is also known as the Discounted Cash Flow (DCF) method. In this method, the intrinsic value of the company is determined by the discounting the future cash flows of the company. The discounting of the future cash flow is done by using the cost of the capital asset of the company.

Once the future cash flow is discounted to present value, the investor would be able to find out the value of the stock to know if the same is overvalued or under-valued or at par.

Asset Approach

The Net Asset Value or NAV is one of the easiest ways to understand the calculation of the valuation of a company. The most important aspect of calculating NAV is to calculate the “Fair Value” or every asset, depreciating as well as non-depreciating asset, as the fair value might differ from the purchase price of the asset in the case of non-depreciating assets or the last recorded value for depreciating assets.

However, once the Fair Value has been determined, NAV can be easily calculated as:

Net Asset Value or NAV= Fair Value of all the Assets of the Company – Sum of all the outstanding Liabilities of the Company

In order to calculate the NAV of the company, some intrinsic costs like Replacement Cost need to be incorporated, which complicates the issue. Also, for an indispensable person who is of utmost importance to the business, also has a replacement cost which is needed in order to calculate the Fair Value of all the “Assets” of the company.  

Thus, the asset-based approach is used to value a company which have high tangible assets wherein it is much easier to calculate their fair value than intangible assets. The idea is to see if the value of the asset is close to the replacement value of the asset, so arrive at the value of the stock.

Market Approach

Also known as the relative valuation method, it is the most common technique for stock valuation.Comparing the value of the company with similar assets based on important metrics like P/E ratio, P/B ratio, PEG ratio, EV, etc. to evaluate the value of the stock. As companies differ in size, ratios give a better idea about performance.

These are different metrics which are used to calculate different parameters of the stock valuation.

  • PE Ratio (Price to Earnings Ratio)

This is the Price/Earnings Ratio, better known as PE Ratio. It is simply nothing but the ratio of the Stock Price divided by the Earnings per Share. In fact, this is one of the most predominantly used technique to calculate if the stock is over-valued or under.

PE Ratio= Stock Price / Earnings per Share

In this particular method, the Profit After Tax is used as a multiple to get an estimate of the value of equity. Although this is the most widely used ratio, it is often misunderstood by many. There is one major issue in using a PE ratio as a stand-alone tool to estimate the stock valuation since the “Profit After Tax” is distorted and adjusted by multiple accounting methods and tools and hence may not give a very accurate result. However, to get a more accurate PE Ratio, a track record of the profit after tax needs to be considered.

  • PS Ratio (Price to Sales Ratio)

The PS Ratio is calculated by dividing the Market Capitalization of the company (i.e. Share Price X Total Number of Shares in the Market) by the company’s total annual sales figure. It can also be calculated per share by dividing the Share Price by the Net Annual Sales of the Company per share.

PS Ratio= Stock Price / Net Annual Sales of the Company per share.

The Price/Sales Ratio is a much lesser distorted figure when compared to the PE Ratio as the sales figure is not affected by the distortions of the capital structure as a whole. In fact, the P/S Ratio comes handy in cases which do not have a consistent track of profits.

  • PBV Ratio (Price to Book Value Ratio)

This is a more traditional method of calculating valuation wherein PBV Ratio (i.e. price to book value ratio) denotes how expensive the stock has become. Value investors prefer to use this method and so does many market analysts.

PBV Ratio= Stock Price / Book Value of the stock

So, if the PBV Ratio is 2, i.e. means the stock price is INR 20 for every stock with a book value of INR 10.

The only issue with this ratio is that it fails to incorporate future earnings and intangible assets of the company. Thus, industries like banking, prefer using this method as the income heavily depends on the value of assets.

  • EBIDTA (Earnings Before Interest, Tax and Amortisation)

This is the most reliable ratio wherein the earnings are considered before calculating interest, tax or even loan amortisation and it does not get affected by distortions in the capital structure, the various tax rates and slabs as well as non-operating income.

EBITDA to Sales ratio= EBITDA / Net Sales of the company.

EBITDA will always be < 1 as interest, tax, depreciation and amortisation would be considered from the earnings.

Conclusion

Valuation analysis of a stock is essential to understand the true value of a stock and should be done with a lot of deliberation. Investing in overvalued stocks pose a risk of losing capital in next market correction as well as offer limited growth opportunities. This is why apart from fundamental analysis , a valuation analysis should be done to assess the viability of the investment. Analysing a company holistically will ensure you are well aware of what you are getting into as well help you manoeuvre your investments better.

Happy Investing!

Disclaimer: The views expressed in this post are that of the author and not those of Groww.