Key Valuation Methods

Ratan Deep Saxena (Asstt Manager (Accounts & Finance))   (2998 Points)

13 April 2010  

Key Valuation Methods

Whether the capital markets are bearish or bullish, most of the investors generally face a common problem as to when to take position in a particular stock and when to exit so that they can maximize their profits.Investors usually want to know the value of stock that they are going to buy, hold or sell. The value of the stock may be the current value or future value. Every investor likes to buy stock at a cheaper market price and sell at a higher price than its actual value. However, the million dollar question is “How to value a particular stock???” Though, there are several methods of valuation, all of them need valuation of the business of company as a whole.


Business valuation is a process and a set of procedures used to determine the economic value of promoter’s interest in the business. Various valuation tools and techniques used by financial experts to determine the price they are willing to pay or receive to consummate a sale of a business. In addition to estimating the selling price of a business, these valuation tools are also used by professionals to resolve family disputes, Mergers & Acquisitions, and many other business and legal purposes.


As observed in various recent capital market booms including IT boom, Real Estate boom, Retail boom, etc. it is observed that usually share prices peak during boom phase and subsequently crash once the sentiment changes which results into major losses for theinvestors. Investor can avoid such situation if they know how to value the stock? Some of the most popular methods of valuation are as below:


(1)   Discounted Cash Flow Method (DCF): This is a widely used method by stock market analysts to value the companies tracked by them. Estimated future cash flows of the company over a period of next 3-5 years are taken into consideration and further adjusted for time value of money. These cash flows are discounted by the weighted average cost of capital for that company in order to arrive at the present value of expected future cash flows. On dividing total cash flows by total number of issued shares, the investor can arrive at the intrinsic value ofthe stock as on date. Needless to mention, if market price is lower than the intrinsic value then the stock is undervalued and vice-versa.

Despite complexities involved, DCF is considered to be most reliable method of arriving at the fair value after taking into account future performance of the organization.


(2)   Price Earnings Ratio (P/E Ratio): It is one of the most popular methods used by retail investors to value the stock. It is calculated by dividing market price by Earnings Per Share (EPS). Lower P/E ratio usually means that the stock is undervalued and there is a scope for appreciation in future. Every industry has a particular trend with respect to P/E ratio and hence,investors compare P/E ratio of companies in the same industry to decide whether a particular stock is undervalued or overvalued.

It may be noted that P/E ratio alone can not be used for decision making and investors should also check quality of profits as well as sustainability before taking a final call. Further, they should also carefully analyse the outstanding liabilities of the Company because P/E fails to cover the same.


(3)   Enterprise Value to Operating Profits (EV/EBITDA): Enterprise Value (EV) is sum total of market capitalization and outstanding long term liabilities. Operating Profit means Earnings Before Interest, Taxes, Depreciation and Amortization. EV/EBITDA is a valuation multiple that is often used in parallel with, or as an alternative to, the P/E ratio. Typically, this ratio is applied while valuing cash-based businesses. An advantage of this multiple is that it is capital structure-neutral. Therefore, this multiple can be used for direct cross-companies application.


(4)   Enterprise Value to Sales Ratio (EV/Sales): EV/Sales is calculated by dividing Enterprise Value by annualised sales of the Company. Generally, EV/Sales method is used for valuation of companies with lower profits / losses, but large turnover.


(5)   Sum of the Parts Valuation: In case of diversified companies, instead of using only one valuation method, each of their businesses are valued separately using appropriate valuation methods and finally total of all businesses is considered for valuation of stock. Example: Larsen & Toubro, ICICI Bank, Mahindra & Mahindra, etc.


Valuation is a highly subjective concept and hence, different people may have different perception of value for the same stock. In a highly dynamic environment whereinvestors try to value stocks, capital market move randomly at its own pace based on various factors including liquidity, general sentiments,  economic scenario, Government Policy changes, etc. Besides these external factors,the stock price of a particular company can also get affected due to variety of internal factors including financial stability, productivity, innovation, risk management, diversification, compliances, etc. Hence, it should be noted that valuation can never be constant.


Afterall, Warren Buffet has rightly said – “Price is what you pay. Value is what you get.”