Stock Valuation – Meaning, Methods & Formulas
While it comes to investing, stock picking plays a crucial role. One should never be in a hurry as choosing stocks for wealth creation is an art. Careful research and patience is needed; You should check several aspects of the company before investing. There are some essential parameters that have to be analyzed and compared with similar companies before picking a stock. For this, we have to firstly understand stock valuation meaning. It is the process by which you find out the value of a stock by certain formulas. Let us learn the methods that are used in the valuation of stocks. The 2 stock valuation methods are absolute and relative.
This approach mainly focuses on finding out the intrinsic value of a stock. Intrinsic value of a stock is the true value of the stock and this can be found by 2 methods namely, dividend discount model and discounted cash flow model.
Dividend Discount model:
This model is based on a theory that suggests that a stock is worth the sum of all its future dividends.
Discounted Cash Flow model:
By this model, we can calculate the current value of the company based on future cash flows.
Using this model, you can compare certain parameters of your stock with other similar assets that would help in deriving the price of the asset. This method includes several techniques like Price Earnings (P/E), Price/Earnings to Growth, Price/Book Value, Price/Sales Value and Price/Cash Flow. Let us learn in detail about these techniques.
a. Price Earnings (P/E):
Using this ratio, one can understand how much an investor is willing to pay for each rupee of a company’s earnings. A stock with higher P/E simply means that investors have higher expectations in terms of earnings of the company. But one also has to remember that a stock with high P/E is simply overvalued. On the other hand, a stock with a low P/E ratio means the stock is undervalued. One can understand whether a particular stock is undervalued or overvalued by comparing it with other similar companies.
b. PEG ratio:
PEG = P/E
Earnings growth rate
PEG ratio of 1 reflects a perfect correlation between the company’s current market value and its projected earnings growth. If this ratio is greater than 1, the stock is considered to be overvalued and if the PEG is lesser than 1, it is considered to be undervalued.
c. Price/Sales Value:
P/S = Price per share divided by Sales per share Stocks that have a lower P/S value are considered to be cheap than the stocks that have a higher P/S.
d. Price/Book Value:
P/BV= Price per share/Book value per share
Book value reflects the net worth. If P/BV ratio is less than 1, it means the investors feel that the company’s assets are overvalued. Whereas a high P/BV indicates that investors believe that its assets are undervalued.
Valuation of stock in trade is very important and any investor should have a clear understanding of stock market valuation methods that will help in taking the right decisions about investing.