September 19, 2024
4 mins read
In simple words, stock valuation means finding out the real worth of a company’s share. As an example, if you plan to purchase a company stock, you would not rely solely on the price on the screen. You would want to know whether that price is a reasonable value. The valuation process to determine the true value is called stock valuation.
Consider this. If you were to buy a second-hand mobile phone, you wouldn't just look at the price. You would look at how new it is, its features, and whether it was worth the money. Stock valuation works in the same way – but for companies.
Whenever you try to find out the value of a company’s share, you are basically doing stock valuation. Now, the market price of a stock is what people are currently paying for it. But here’s the twist – just because people are paying that much doesn’t always mean that’s its true value.
As an investor, your job is to figure out whether the stock is undervalued (worth more than its market price) or overvalued (priced higher than what it’s really worth).
If the stock’s true value is higher than the current market price, you’d want to buy it.
If the stock’s true value is lower than the current market price, you’d likely sell it.
This way, stock valuation helps you make smarter choices instead of just guessing.
There are mainly two types of stock valuation. Let’s break them down:
This method looks only at a company’s own financial data – no comparisons with others. It checks things like expected cash flow, profits, and dividends. It’s good for companies that have steady earnings.
Some models used here are:
Discounted Cash Flow (DCF) – future cash flows brought to present value.
Dividend Discount Model (DDM) – calculates value based on dividends.
Asset-based Valuation – focuses on the company’s assets and debts.
This one compares a company with other similar companies in the market. It uses ratios like:
Price-to-Earnings (P/E)
Price-to-Book (P/B)
It basically helps you see if the stock is cheap or expensive compared to its peers. This is the method most beginners find easy and practical.
Here are some popular methods you’ll come across:
This works only for companies that pay dividends regularly. The idea is – the company’s value equals the present value of all its future dividends.
Here, you look at the company’s future cash flow (money coming in) and then calculate what that’s worth today. This gives a fair value of the company.
This is a quick comparison tool. It shows how much investors are willing to pay for every rupee of a company’s profit.
If a company’s P/E is lower than its competitors, it may be undervalued → a good buy.
If the P/E is higher, it might be overpriced → better to avoid or sell.
This is another way to compare one company's results with other companies in the same industry. You can look at the profits, revenues, cash flow, and book value.
For example, if the P/E ratio for Company A is considered valuable due to being lower than similar companies, an investor could evaluate Company A for potential undervaluation. But here’s the catch – you should compare companies that are almost the same in size and structure, otherwise the comparison won’t be fair.
Here’s a simple table to help you see the pros and cons:
Advantages | Disadvantages |
Helps you find if a stock is undervalued or overvalued. | No method is 100% accurate, results can differ. |
Guides you in making smart buy/sell decisions. | Needs time, knowledge, and proper financial data. |
Lets you compare companies fairly. | External factors like market mood or economy can affect accuracy. |
Reduces risk of blind investing. | Some models (like DCF) are tricky for beginners. |
One of the most common tools investors use is the P/E ratio. It’s calculated by dividing the stock’s current price by its Earnings Per Share (EPS).
A high P/E usually means the market expects strong growth from the company.
A low P/E could mean the stock is undervalued – or that the company has weak growth prospects.
But remember – a P/E ratio only makes sense when you compare companies from the same industry. Comparing a bank’s P/E with a tech company’s won’t give you any real insight.
As a novice, don't focus on a single method. Try a range of methods like P/E, DCF, and comparables. With more practice, you will be increasingly better at recognising good opportunities.
So, stock valuation is nothing more than figuring out the real worth of a company’s share. You don’t have to be a finance wizard to get started – just curious and willing to learn.
Consider stock valuation as your magnifying glass, allowing you to look beyond the shiny market price and determine whether you should buy, hold, or sell a stock, but only after careful consideration. With more practice, you'll eventually start thinking like a professional investor.
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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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