What is Stock Valuation and How it is Calculated?
Stock valuation refers to finding what a stock is worth. Every stock has a business
behind it and it is this business that determines the worth of the stock. If the
business prospects are good then the stock normally performs well in the long term
and if the prospects good then the stock will underperform. Stock valuation attempts
to find the intrinsic value of a stock and then takes a decision on whether the
share should be bought or sold.
Why is Valuation Important
A stock is the representation of a very complex business. A business represents
the past and the future prospects of a company. Valuation is important because you
need to put a number to what a company is worth and that eventually reflects in
the price. In the short term there may be divergence between valuation and price
but in the long run, the stock price tends to converge towards the value. That is
why it is said that stock markets are like a slotting machine in the short run but
like a weighing machine in the long run.
What are the Steps Involved in Valuation
Projecting future cash flows
A business is valuable because of the cash that it generates over a period of time.
Cash flow is king and therefore valuations will commence with projecting future
cash flows. You take the current cash flow as the base and project the future cash
flows based on your projection of future sales and profit margins. This is the first
step in valuation.
You discount the future cash flows to the present
There is something called time value because money earns interest. Rs. 100 today
will be worth Rs.110 after 1 year if the rate of interest is 10%. In other words,
the present value of Rs.110 you earn after one is worth Rs.100 today. The same logic
applies to future cash flows too. The projected future cash flows have to be discounted
back to the present by using an appropriate discount rate.
Considering the qualitative factors in a stock
Valuing a stock is not just about mathematics but also about quality judgements.
Why are some stocks more valuable than others? Apart from size, such stocks also
have other advantages like strong brands, distribution networks, entry barriers
etc. Such qualitative factors add to the value of the stock and they need to be
factored in when you cannot consider the financial value discounted by future cash
flows. You need to consider qualitative inputs too.
Comparing with industry P/E ratios
The next step is to ratify your valuations with comparable industry P/E. Here you
compare the P/E ratio implied by your valuation with the peer group and the industry
average. P/E Ratio is the price that the market is willing to pay for each rupee
earned by the company. Different industries have different P/E levels based on a
variety of factors like brand value, future growth, return on equity etc. Such a
P/E comparison helps you to understand whether the valuation you arrived at is reasonable
Checking for the margin of safety
Once the valuation is done, how do you arrive at the decision to buy or sell a stock?
That is where you look at margin of safety. The margin of safety shows the extent
to which the market price of the stock is below the valuation that you arrived.
Only if the margin of safety is really large does it make sense for you to buy the
stock. This is a popular concept used by very successful investors like Warren Buffett
Final Check List After Valuation Exercise
Once you have valued a company and arrived at a value, it is called the fundamental
value. Even if you are convinced about the margin of safety, your checklist should
include two more steps before making the final buy / sell decision.
Are the charts suggesting a good entry point?
Even the best of value based investors use technical charts to decide upon the timing
of the entry. What is the best support level for the stock or has the stock broken
above a crucial resistance level are questions that you need to ask. By using technical
charts, you can improve your entry and exit level and thus increase your return
on investment (ROI).
Take a macro view before taking a call on the stock valuation
You really cannot look at stock valuation in isolation and there is a context that
you need to understand. In this case, the context can be the macros. For example,
if inflation is rising, or interest rates are on their way up or oil is boiling
then even the best of valuation picks will underperform. Ensure that the macros
are supportive of the stock buy / sell decision.