Trading in stocks demands patience. This means that before committing to a company, it’s crucial to assess its financial health and future prospects, as these directly impact profitability and, consequently, your investment returns.
A key method for evaluating whether a stock is a sound investment is through valuation. Valuation involves determining the true value of a stock by analyzing various parameters to gauge whether the company is overvalued, undervalued, or fairly priced.
Here’s how to conduct a thorough valuation analysis to determine if a company is a viable investment option.
Methods used to do Valuation Analysis of a Company
Doing valuation analysis helps you understand if a company is undervalued or overvalued. Let us look at some of the methods by which the valuation analysis can be done.
1. Income Approach
The income approach of valuation is also known as the discounted cash flow method (DCF). Here, by discounting future cash flows, the intrinsic value of the company can be determined. The future cash flows are discounted based on the company’s cost of capital.
This helps determine whether the company is overvalued, undervalued, or correctly valued.
2. Asset-Based Approach
The asset-based approach is used to value companies with high tangible assets. Oy uses the Net Asset Value (NAV), which is a straightforward method for understanding a company’s valuation.
The key step in calculating NAV is determining the “Fair Value” of each asset, both depreciating and non-depreciating. Once the Fair Value is established, NAV can be easily computed as:
Net Asset Value or NAV = Fair Value of all the Assets of the Company – Sum of all the outstanding Liabilities of the Company
3. Price-to-Earnings (P/E) Ratio
The Price/Earnings Ratio, commonly referred to as the PE Ratio, is calculated by dividing the Stock Price by the Earnings per Share. It is widely used to assess whether a stock is overvalued or undervalued.
PE Ratio = Stock Price / Earnings per Share
This approach uses the Profit After Tax as a multiplier to estimate the value of equity. Despite being the most frequently used ratio, it’s often misinterpreted by many.
4. PS Ratio (Price to Sales Ratio)
The Price-to-Sales (P/S) ratio is determined by dividing the company’s Market Capitalization (which is the product of the Share Price and the Total Number of Shares) by the total yearly sales. It can also be computed on a per-share basis by dividing the Share Price by the company’s Net Annual Sales per share.
The P/S ratio is calculated as follows:
PS Ratio = Stock Price / Net Annual Sales of the Company per share.
Compared to the P/E ratio, the P/S ratio is less distorted. This is because the sales figure is not influenced by the distortions of the capital structure. In fact, the P/S ratio is particularly useful in situations where profits are not consistent.
5. PBV Ratio (Price to Book Value Ratio)
The Price-to-Book Value (P/BV) ratio is a more conventional method of assessing valuation. It indicates how costly the stock has become. This method is favored by value investors and many market analysts.
The P/BV ratio is calculated as follows:
PBV Ratio = Stock Price / Book Value of the stock
For instance, if the P/BV ratio is 2, it implies that the stock price is Rs 20 for each stock with a book value of Rs 10.
Conclusion
Valuing a company requires an analytical approach that uses multiple methodologies to ensure accuracy and reliability. Each of these methods provides unique insights into a company’s worth.
Knowing how to determine a company’s value also helps you understand and learn stock market investing better. You can also take online courses from Upsurge.club to level up your valuation skills and make informed decisions.