One of the richest men on Earth, Warren Buffet, is a value investor. Anyone with a Demat account must have wondered how stock valuations are determined. We often find ourselves looking for undervalued stocks in Indian markets, hoping to make money when these stocks grow to a fair price.
Some investors might worry that the stocks they have bought are now overpriced. But, knowing the true value of a business is a difficult task. It requires an understanding of the business, the industry standards, and conducting or understanding fundamental analysis.
Various tools can be used to know if a stock is valued correctly or not. This blog explores some of the factors to consider while analysing a stock’s valuation.
How to determine company valuations?
The quickest way to gauge a company’s valuation is by checking the valuation multiples like price-to-earnings ratio (P/E ratio), price-to-sales ratio (P/S ratio), and EV/EBIT. To better understand the valuation, you can compare these multiples across the industry and market capitalisation segment.
Overvalued companies would tend to have valuation multiples higher than the industry average. Similarly, undervalued companies tend to have valuation multiples lower than the industry average.
Company Valuation Measuring Methods:
P/E Ratio
The P/E ratio is commonly used to know what the valuation of a company is. The price-to-earnings ratio is measured by dividing a stock’s price by earnings per share (EPS). A more direct way to measure the P/E ratio would be to divide the market capitalisation by the total earnings. The P/E ratio is sometimes called the price multiple or the earnings multiple.
P/S Ratio
Price-to-sales ratio (P/S ratio) is measured by dividing a company’s market capitalisation by the total sales value in the past 12 months. The P/S ratio is useful for learning how the market values every Rupee of the company’s sales.
EV/EBIT
Some organisations may have a lot of debt. So, P/E and P/S ratios may not capture the valuation of a company. You may need to use the enterprise value to learn the valuation in such cases. Enterprise value is measured by adding market capitalisation to a company’s total debt. EBIT refers to earnings before interest and taxes.
Formula for EV/EBIT:
How to determine the valuation of high-growth companies?
Companies in the middle of their high growth periods would be valued according to the expected growth in their earnings and not the current year’s earnings. Valuation multiples like the P/E ratio measure the valuation according to the latest earnings data available and so might not be able to capture a growing company’s valuation. High growth companies might sometimes enter the highest valuation companies list. PEG (price/earnings-to-growth) ratio may be a better fit for learning the valuations of growing companies.
What is PEG Ratio? How to calculate the PEG ratio?
PEG ratio is measured by dividing the P/E ratio by the growth rate of the company’s earnings for a specific period. Since the PEG ratio considers not just the earnings but their growth as well, it is thought of as a more complete valuation multiple than the P/E ratio.
Formula for PEG ratio:
What is a good PEG ratio?
| PEG Ratio | What does it tell you? |
| Less than 1 | Undervalued |
| Equal to 1 | Valued fairly |
| More than 1 | Overvalued |
Ideally, the PEG ratio would be equal to 1 if a company is valued fairly after taking the growth aspect into account.
NOTE: PEG ratio depends heavily on the earnings growth rate entered. In some cases, people may enter the expected earnings growth rate. You can gauge the true valuation of a company only if the expectations about future earnings are accurate.
Value Traps
There are chances that companies with low valuation multiples might actually fall in value. Similarly, some stocks may look like good picks for short selling as their valuation multiples are way above the industry average, but they might retain the stock price or grow even further. Such stocks are called value trap stocks. Some companies that aren’t doing so well might attract investors through their attractive dividend yields. Such companies are called dividend yield value traps.
Avoiding value traps is difficult. However, by going deeper in your fundamental analysis, you may be able to identify them. Some indicators of value trap stocks are:
- They might be underperforming in their sector
- Declining Market Share
- Underperforming on expectations
- Being dependent on products with seasonal surges or products whose performance varies according to economic conditions
Trades Made By Company Insiders
Insiders of a company (top executives, directors, etc.) are positioned in a way that they can receive information about the performance and prospects of the company before others. Thus, the market always keeps an eye out for any news about insider trading activity. Data about trades made by company insiders are available on sites like TickerTape and MoneyControl.
Typically, these individuals know that stock market participants follow insider trading news. So, company insiders like directors are reluctant and often delay selling shares of their company.
Is the Indian Stock Market Overvalued or Undervalued? – Read from this blog
Final Thoughts
Learning the true value of a business is difficult. This process can be eased by keeping tabs on insider trades, value traps, and valuation multiples. Knowing the business and the industry standards for valuation multiples can help you determine a business’s real worth.
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FAQs
Valuation multiples like P/E ratio, P/S ratio and EV/EBIT are used for learning the real worth of a stock. If you cannot figure out the true value of stock even after studying the valuation multiples, you would need to go deeper into your fundamental analysis.
Warren Buffet is a well-known value investor. He follows the Benjamin Graham school of value investing. He believes that you should only invest in businesses you can understand. He also looks at factors like moat and margin of safety.
Price-to-book value ratio (PB ratio) is the amount investors are willing to pay for a share in the company’s asset. Traditionally, a PB ratio of 1 is for a fairly valued stock; anything above 1 is considered overpriced, and anything below 1 is underpriced. This, however, varies basis sector and macroeconomic factors.
If a stock is truly overvalued, it might be wise to sell it off rather than holding until the prices correct.
