Valuation Meaning and how to use it to pick stocks?

Valuation refers to the process of determining the stock's true value beyond the market-listed price. This is the effort of the investor to understand the market dynamics and demand-supply effects that can affect stock prices over the short term. Surely, long-term, companies that have actual value will be those that produce returns.

Investors have many options for valuation. You should choose one that appeals most to your logic. There are six types and two categories of valuation models.

Let's look at six common methods of valuing so you can decide which one (or combination) works best for you.

Valuation Models

Absolute valuation is the first type, which some investors call absolute value. It involves examining a company individually and determining its potential using certain parameters. Two methods can be used to determine absolute value, including dividend discount and discounted cash flow.

The second type of valuation, also known as relative valuation, makes use of comparisons to assess the potential of a stock. This category includes the following models: PE ratio, PEG Ratio, Price/Book Ratio, Price/Sales ratio and Price/PE ratio.

Let's start with relative valuation ratios, which are quite simple to calculate.

Relative Value Methods

PE Ratio comparison

This ratio compares a company's stock price and its earnings over a period. This indicates how much an investor is willing to pay for 1 share in the company's earnings.

As of 8 July 2021, Karnataka Bank's P/E ratio was 3.96, while SBI's P/E is 18.57. Investors in Karnataka Bank are charged Rs 4 per Re1 of its earnings while investors in SBI are charged Rs 18 for each Re1 of its earnings.

PE Ratio = Stock market price / Earnings per Share

Investors can use the PE ratio in two ways. Investors can use PE ratio to compare it with a benchmark index. They can also compare the PE ratios of companies in the same industry.

Investors have high expectations of the company, and will therefore pay more than their current earnings to acquire it. Lower PE means that the stock's earnings are not as good as expected and is therefore trading at a lower market price. Investors use this method to determine the company's intrinsic value.

Let's take, for example, an investor who is interested in buying stocks of company X at a PE Ratio 10. Company X's sector has company Y and company Z with a PE Ratio of 10. Investors get the feeling that the stock price for company X may be justified at the moment and it might be worth the investment.

A stock with a low PE ratio is usually considered undervalued. Conversely, a stock with a high PE number is thought to be overvalued. Investors should not ignore stocks falling in either of these categories. This is only an indicator of the current stock price.

Warren Buffet, the famous investor, and Benjamin Graham, his mentor, have a strategy called Value Investing. This involves buying stocks with a low PE ratio. They believe that buying stocks at a discount means you're buying stock that is undervalued. They believe that undervalued stocks will experience an upward price correction and investors will be able take in substantial earnings.

PEG ratio comparison

The PE ratio model is identical to this model, but it also includes the growth rate for earnings. While PE ratio is often criticized for limiting value to the market price, PEG projects earnings growth by using a projection. If you look at the company's earnings growth rate, a stock may appear "cheap" and "expensive". The PEG ratio gives a more accurate picture of a company's value.

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

Let's say company X earns Rs 10 lakh in a fiscal year. At the time, its share price was Rs 10 and there were 1.2 lakh shares outstanding. The company's EPS grew by 1% in the past year, and it is expected to grow by 1.5% in the next year.

Its EPS for the financial year is therefore Rs 8.3 (120000/100000).

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

Hence, PEG ratio = 1.20 /1.5 = 0.8

If the market correctly assesses the company's worth, a PEG ratio of 1 is achieved. The earnings are equal to the share price. If the PEG ratio falls below 1, it is considered an ideal investment option because of its market 'undervalue' assessment. It is also possible to have a PEG ratio greater than 1. This indicates that the market expects a faster increase of earnings or that the stock has been overvalued.

Price-to-book ratio comparison

This model compares the net value of all assets on the company's balance sheets to determine a company valuation.

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

A low PBV means that investors won't pay a premium for the stock, even though the assets are worth it. This could be due to market sentiment or a fundamental problem with the company. This is usually a sign that the stock is undervalued.

A high PBV ratio indicates that the stock trades at a premium, even though the company's net assets are not justified. This company could be considered overvalued.

Price-to-sales ratio comparison:

This ratio, as the name implies, takes into account the company's sales figures in order to calculate a number that represents its intrinsic value. This ratio measures how much revenue a single share of a company generates relative to how much it costs to purchase one share.

A low price-to–sales ratio, like other relative valuation methods, means that investors won't pay a high stock price even if the sales justify it. This is usually a sign of an undervalued stock. A high price-to sales ratio usually indicates that investors are willing to pay more for the company's sales.

PS Ratio = Revenue / Market Capitalization

Similar to the PE ratio, if an investor discovers stocks of company X that have a PEG (or a value to book ratio or a price-to-sales ratio) higher than those of company Y and company Z in the same industry, the investor should be aware that company X is currently trading at a higher price than it is justified.

Absolute Valuation Models

Discounted Cash Flow

Cash flow is the amount of money that moves into and out of a company. This model is able to predict both the company's earnings and expenditures, which is a credit to its creators.

This formula is used to calculate discounted cash flows:

DCF = 1+r)t

CFt is cash flow that occurred during the specified time period.

The discount rate r is related to the cash flow's riskiness.

The asset's life value is t.

This method analyzes the potential of a company over 5 to 10 years based on cash flow numbers.

Investors will add "terminal value", which is a calculation that attempts to determine the business's value for the remainder of its life (above the DCF formula).

DCF's two biggest drawbacks are its complexity, which may not be suitable for amateur investors, as well as the fact that it can't be used by companies with negative cash flows. Investors might be concerned if there is negative cash flow.

Dividend Discount

This method determines a company's current value by subtracting any dividends it might pay to shareholders from its current value. This method is problematic because, as you might have guessed, not all companies pay dividends. They may also not make payments at regular intervals.

Dividend Discount is a good model because it calculates how much the investor will actually receive during his stock investment. Dividends are the only income that the investor can earn until he or her sells the stock.

After the Dividend Discount has been calculated, it can then be compared to the current stock price to determine if the stock is under or overvalued.

Stock value = DpS/(Dr. - DGr

Where?

DpS stands for Dividend Per Share

Dr. Discount Rate also known as Cost of Equity

DGr stands for Expected Dividend Growth Rate

This method is far easier than the DCF one. It tracks dividends and their growth rate to project future growth rates. The projected growth rate is what the investor uses to decide whether the stock is worth investing in.

Conclusion

These valuation methods can help you make better investment decisions. Relative valuations may be more appealing for beginners and people who don't like to work with formulas and numbers. However, not all companies can be accurately analysed using every method. You can use your discretion to double-check a company's potential by using other methods. Investors need to be aware that valuation can be used to help them make informed decisions and forecasts. However, it is not a guarantee that you will earn on your choices based on these educated predictions. Before investing, investors should consider their risk appetite.