- Date : 28/04/2021
- Read: 5 mins
Here’s how to learn about important stock valuation techniques.
Almost 49 lakh new demat accounts were opened during financial year 2020. Between January 2020 and September 2020, retail investors directly bought stocks by investing close to US $12 billion. There were multiple factors behind this surge:
- Due to pay cuts and job losses across the board, several individuals started dabbling in stocks as an additional source of income.
- Since work from home is the new normal, retail investors had time to start investing apart from doing their regular office work.
- An aversion towards mutual funds was seen due to higher fees and lower returns.
However, with the Nifty 50 index doubling from 7511 points in March 2020 to more than 14,000 points by the end of 2020, it becomes important to evaluate whether stocks are still fairly valued.
What is stock valuation?
Stock valuation is primarily used to calculate the intrinsic value of a stock. The intrinsic value of any stock is its true or actual value. Its fundamental importance is that the inputs to stock valuation by any method are independent of the current market price of the stock. This allows investors to compare the intrinsic value derived by this method with the market price of the stock, thereby ascertaining whether the stock is over-valued or under-valued.
Now, let us take a closer look at the types and methods of stock valuation.
Absolute stock valuation refers to valuing the business independent of external factors like industry, competitors, etc. The intrinsic value derived by such methods predominately revolves around the company’s own fundamentals. There are two famous methods for absolute stock valuation: Dividend Discount Model and Discounted Cash Flow Model.
The inputs to both these methods include the company’s own numbers such as dividends, cash flows, growth rate, cost of funds etc. The larger vision of the company’s fundamentals is translated into a single number – the intrinsic value, which is then compared to the market price of that company.
Dividend Discount Model
The value of any asset is the present value of future cash flows. The Dividend Discount Model is based on the principle where future dividends are the cash flows available to the shareholder. The model is applicable to companies where the dividend payout is regular and stable.
For instance, if a company is paying a dividend of Rs. 2 per share, which is growing at a constant growth of 8 percent, the value of the share of this company will be simply Rs. 2.00/0.08 = Rs. 25 per share. So, in our example, Rs. 25 is the real or intrinsic value of the stock based on the Dividend Discount Model.
The investor can then compare the market price of the stock with this intrinsic price and decide whether the stock is overvalued or undervalued.
Discounted Cash Flow Model
The Discounted Cash Flow Model is another model based on the concept of present value of future cash flows. In case of companies where the dividend payout is not regular and stable, analysts prefer using this method. The true value of the stock is the discounted value of a company’s free cash flow. Mature firms, especially those past their growth stage, usually employ Discounted Cash Flow Model.
Relative stock valuation refers to methods that use inputs outside of the company such as industry growth, industry valuation, peer companies’ financial ratios etc. It is a relative method and the valuation matrix is compared with the industry benchmarks.
Comparable company analysis
This is a relative stock valuation technique, and it derives the valuation of a company by using the valuation matrix of a peer firm in the same industry. Instead of using the company’s fundamentals as inputs to a valuation model, analysts start the valuation exercise by taking the price multiple of similar comparable firms of the same industry after adjusting for specific differences.
Many analysts use this valuation method to complete a sense check on the overall numbers and to form a concrete view of the company. This method is theoretically easier and technically less complicated to use.
What are some common price multiples used?
The most common price multiples used for this method are price-to-earnings (P/E) ratio, price-to-EBITDA, price-to-sales, etc. Such a method is effective for new companies in the industry where there is not much data available historically, or if the company is yet to break even or turn a profit.
In the stock markets, there is a saying in Gujarati, ‘Bhaav Bhagwan Che’, which implies that price is everything. Hence, it is important to identify profitable, growing companies available at dirt cheap prices.
For example, the P/E ratio of Tata Motors was hovering around 10 in October 2018 whereas the industry PE was at 45. The company has shown tremendous growth in the last three years, and multiplied investors’ wealth by nearly 2.5 times.
Another example with a longer time frame would be HUL. It was trading at PE of 21 times whereas the industry standard was above 50 times. The consistent profitability and growth in the financials supported by a fancy valuation allowed the stock to perform well over the last 10 years. The stock price has gone from Rs. 300 in October 2010 to almost Rs. 2500 in April 2021, delivering more than 8x returns over a period of 10 years.
In practice, analysts prefer using the price multiples valuation model in addition to any of the absolute valuation techniques to form a concrete and conforming view of the company. The reason for using price multiples is that there is enough exposure of the industry that will be considered in the valuation modelling. A mix of the company’s own fundamentals and the industry dynamics will give a true picture and a more accurate valuation matrix. Look at these 6 Common stock trading mistakes you should avoid.