In this article, You will learn about stock valuation methods or how to identify whether the stock is at the right valuation, overvalued, or undervalued. So that, you can have a better idea and confidence after buying a stock.
To know the valuation of stocks, there are some stock valuation methods. In this article, we have discussed some basic stock valuation methods which everyone can easily understand and use.
Most of the beginners in the stock market don’t know how to use stock valuation methods. They just byheart some stock valuation methods and think that if the stock comes to that range it is a buy signal or sell signal.
But if you invest like that, you will become a good valuer, but not a good investor. Because if you are investing only by stock valuation methods, you can never invest in companies like Apple, Amazon, Google, or any new age Businesses.
As a good investor, when you are assessing any company, you need to analyze and give 70% off the weightage to the company business model, growth opportunities, weaknesses, financials of the company, and management analysis. Remaining 30% of the weightage for stock valuation.
Stock valuation methods
Basic stock valuation methods:
Mostly, everyone knows about the PE ratio. But, now let’s understand how to use the PE ratio in a correct manner for stock valuation.
PE RATIO = CURRENT SHARE PRICE / EARNINGS PER SHARE
The current share price of the company is divided by earnings per share. Now, you might have got a doubt, that how to calculate earnings per share.
EPS = NET PROFIT / TOTAL NO OF SHARES
For example, If the profits of the company for this financial year is 10k, the total no of Shares is 1K and the price of the stock is 100 rupees.
Then EPS = 10K / 1k = 10.
PE = 100 / 10 = 10.
Here, we don’t need to calculate EPS and PE for each and every company. The values for EPS and PE are available on a lot of websites. For example, the parameters are available in Screener.
PE represents how many times we are paying for one rupee earning. In the above example, we are paying 10 rupees for 1 rupee earning.
PE Ratio importance
The biggest question for beginners is, they listen to others saying that, the stock is trading at 15 PE multiple or 20 PE multiple or even100 PE multiple. But they don’t know what is the significance of it.
If we see as per the book.
|12 TO 15||VERY ATTRACTIVE|
|15 TO 20||ATTRACTIVE|
|20 TO 25||EXPENSIVE|
|ABOVE 25||VERY EXPENSIVE|
This is as per the book. But we have already learnt at the beginning of this article, that is, buying the stock only by seeing range, we can’t decide the stock valuation.
After analyzing the company growth, business, management, and financials. Lastly, we need to Conclude by using stock valuation methods.
The main thing to remember before using the PE ratio is, it is used only for the stocks in the same sector. Don’t use it to compare the stocks in two different sectors.
For example, you can compare TCS and Infosys or Dabur and ITC. Both TCS and Infosys are IT sector companies. Dabur And ITC are FMCG sector companies. But don’t compare TCS and ITC, as they are from different sectors.
Advantages and disadvantages of PE ratio
The PE ratio is very easy to understand, but the PE ratio has some challenges while analyzing the stock valuation.
PE does not consider the future growth scope of a company. because PE is calculated based on current net profit and share price.
For example, in the Covid period, almost every company has a huge fall in their earnings. If the earnings are low, then it will result in an increase in PE. If the PE is high then the stock is considered as overvalued. But it is not correct in this case, because the earnings are affected due to the Covid lockdown.
Another example is, due to china plus one theme, some companies may benefit in the future, But their past earnings are not so good. In this case, the PE ratio will not consider the future growth scope of the company and the present PE ratio of the company is high as the company past numbers are not so good.
PE Ratio is calculated based on earnings. Fraud management may manipulate the earnings of the company, which results in low PE value.
PE ratio will not consider the quality of the earnings. For example, if a company is making good profits by increasing their debt, PE will only consider the earnings, but not the increasing debt of the company.
By using PE we are not considering the quality of the earnings. Another way of valuing a company is by using the P/CF ratio. P/CF Ratio Is Better Than PE While Valuing The Quality Of Earnings In Stock Valuation Methods.
P/CF means price to cash flow ratio.
After calculating the P/CF ratio of a company, by comparing the ratios with other companies in the same sector, we can understand that the company which is trading at a low P/CF value is at a reasonable price compared to other companies.
You don’t need to calculate the P/CF ratio for every company, there are websites available that gives us the details of almost every parameter.
You Can Use Screener . Search By Company Name And Then You Can Add Whichever Parameter You Want By Searching The Parameter Name In ”Add Ratio To Table”.
Here, the P/CF ratio addresses the challenges in the PE ratio. where PE ratio does not consider the quality of earnings and the earnings can be manipulated by the company, which results in a low value of PE.
In the Case of P/CF, it considers the quality of earnings. Because in P/CF, we are considering cash flow statements and it is not that easy to manipulate cash flow statements. But still in the P/CF ratio also we are using the cash flow statement of last year and we are not considering the future growth of the company.
The company may generate good cash in future. The parameter which considers the growth of a company is the PEG ratio.
PEG means Price to earnings to growth ratio.
To Know The Annual EPS Growth You Can Use Tijori Finance And Go To Financial Section, There You Can Find Annual EPS Growth In Growth Table. If You Don’t Have Tijori Account, You Can Use Screener. In Screener At Bottom Of Profit & Loss You Can Find Compounded Profit Growth. You Can Use That To Calculate The PEG Ratio.
While calculating the PEG ratio, we need to take the 5 years EPS growth average. Because there may be abnormality growth in one or two years. To decrease the error, it is better to take 5 years of EPS growth.
From the PE ratio example, the PE of the company is 10. Assume that the company’s 5 years EPS growth is 20%.
PEG = 10 / 20 = 0.5.
The company is available at a 0.5 PEG ratio. As per the book, If the PEG ratio is below 1, then the company is at attractive valuations. If PEG is 1 then the company is trading at the right valuations. If PEG is above 1 the company is trading at expensive valuations.
But remember these are as per the book. In reality, there are very few stocks that trade below 1 PEG ratio. So, we can take a buffer up to 1.5 – 1.75.
PEG addresses the challenges of both PE and P/CF. But still, PEG also has some challenges. While calculating PEG we are considering EPS growth for the past 5 years and assuming that the company will perform the same or even more in future.
But, if the company doesn’t perform well in future, our assumptions and calculations will go wrong.
For each and every parameter there are advantages as well as disadvantages. We need to understand the disadvantages in the right way, then only we will know how much risk we are taking or the chances of our calculations going wrong.
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