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.
There are broadly two types of stock valuation methods: absolute valuation and relative valuation. Under absolute valuation, we have methods that try to find the true or intrinsic value of a stock. To find the true value, we focus on the fundamentals of a company, like how much dividends it pays, how much free cash flow it generates, etc. Under this approach, we don’t compare the valuation of a company with that of other similar companies. Common methods used under this approach are: discounted cash flow model, dividend discount model, etc.
Under relative valuation, we compare the multiples like price-to-earnings (P/E) of a company with that of similar companies to find out whether it’s over- or under-priced. As we compare companies with each other, it’s called the relative approach towards valuation.
Let’s discuss a few popular methods of stock valuation.
1) Dividend Discount Model or DDM: 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.
2) Discounted Cash Flow Method or DCF: 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.
3) Price-to-Earnings (P/E) Method: 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.
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.
For All Disclaimers Click Here: https://bit.ly/3Tcsfuc
Textile Sector in India
20 Sep, 2024 | 11 Min. read
Commodities Market Today | WTI Crude Rises 1.4%, Gold And Silver Prices Increase
20 Sep, 2024 | 1 Min. read
Share Market Today | Gift Nifty Hints At A Positive Opening For Indian Markets
20 Sep, 2024 | 4 Min. read
AU Small Finance Bank Partners With Niva Bupa Health Insurance
20 Sep, 2024 | 4 Min. read
Adani Group To Acquire 46.64% Stake in ITD Cementation India
20 Sep, 2024 | 4 Min. read
NTPC Approves ₹9,701 Crore Investment In Sipat Stage-III
20 Sep, 2024 | 4 Min. read
SEBI Bars Axis Capital From New Debt Segment Roles
20 Sep, 2024 | 4 Min. read
Gold Rate Today | Gold Rises 0.5%, Silver Increases 1.5%
20 Sep, 2024 | 2 Min. read
Hong Kong Cuts Interest Rates by 0.5% After Fed Eases
19 Sep, 2024 | 4 Min. read
NTPC Green Energy Files ₹10,000 Crore IPO Draft
19 Sep, 2024 | 4 Min. read
US Federal Reserve Cuts Interest Rates by 0.5%
19 Sep, 2024 | 4 Min. read
Margin in Leverage Trading: Definition, Working & Differences
19 Sep, 2024 | 4 Min. read
Analysis to Become a Pro Investor
28 Dec, 2023 | 4 Min. read
Women In Real Estate Investing (Investree)
28 Dec, 2023 | 5 Min. read
How To Check Prudent Corporate Advisory IPO Allotment Status
27 Dec, 2023 | 3 Min. read
How To Boost Credit Score? – Steps to Improve Creditworthiness
27 Dec, 2023 | 4 Min. read
Advantages and Disadvantages of Opening Multiple Demat Accounts
26 Dec, 2023 | 4 Min. read
7th CPC LTC: Leave Travel Concession Rules for Central Government Employees
26 Dec, 2023 | 4 Min. read
7th Pay Commission: House Building Advance (HBA) Interest Rate FY 2023-24
26 Dec, 2023 | 5 Min. read
The Future of Trading: Exploring Bajaj Broking’s Demat Features
26 Dec, 2023 | 6 Min. read
7th Central Pay Commission Cpc Fitment Table
23 Dec, 2023 | 7 Min. read
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.
No Result Found
Level up your stock market experience: Download the Bajaj Broking App for effortless investing and trading
TRENDING CALCULATORS AND STOCKS ON BAJAJ BROKING
