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What is Stock Valuation and How it is Calculated?

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 or not.

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 globally.

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.

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