Valuing a stock is an important aspect of evaluating a prospective investment decision. There are different methods of valuing a stock. Few methods take profits generated by the company as a crucial factor in the evaluation and few concentrates on other aspects of the company that helps in deriving the present value of the stock. Let us know about different valuation methods in crisp.
Discounted cash-flow model, in simple terms, focuses more on the projections of the free cash-flows generated by a company and discounting them to the present value. There by deriving the fair value of the company.
The result of the fair value in this method varies from analyst to analyst because of the different discount rates and different projections of cash flows. Thus, deriving fair value through the DCF is a complex process for a DIY investor, and DCF is widely used by professionals who are handling the sectors or particular stocks.
However, there are other ways to value a stock and arrive at the fair value of a company, that a retail or layman investor can easily understand and implement in their evaluation process and we must remember that all the valuation methods have their own limitations including DCF.
The Other Valuation Methods are as follows:
Price/Earnings (P/E) is a common valuation method that is mainly based on the price and EPS of the company. It tells us how many years of earnings by a company will give us the price we are paying for the stock today.
Now let us say a company ‘AAA’ whose Earnings Per Share (EPS) is 50 and the stock price is 150, thus P/E of the stock is 3. Consider another Company ‘BBB’ whose earnings per share is 25 and the stock price is 50. Thus, in case of BBB the P/E ratio is 2.
Theoretically, the lower the P/E the more attractive investment. We must remember that the P/E ratio is different for the stocks of different industries. Thus, one should always compare the P/E ratio of stocks with its peers only.
As growing companies deserve higher multiples and stock markets are forward-looking, the forward P/E ratio (based on the future earnings potential) is more important than the trailing P/E ratio of a stock.
The price to Earnings to Growth (PEG) Ratio, popularized by Peter Lynch is another widely used valuation method. if PEG is equal to 1, then the stock is fairly valued. To understand the usage of the PEG ratio clearly, let us give you a small illustration.
The Formula for the PEG Ratio is as below
PEG = Price/Earnings/Growth of EPS.
'Price' is the current market price of the stock.
'Earnings' = (Net income – Dividends)/No: of equity shares Outstanding
'Growth of EPS' – CAGR of growth over 3 to 5 years period (Trailing or Forward)
Consider a stock ABC with a P/E ratio of 10 and a growth rate of EPS at 6%. Then the P/E to Growth (PEG) Ratio of the stock ABC is 1.67% which says that we are paying more for the growth expected in the stock's earnings.
Now consider a stock XYZ with a P/E ratio of 5 and a growth rate of EPS is 10%. Then P/E to Growth (PEG) Ratio of the stock ABC is 0.5% which means you have found a good bargain for yourself in the markets.
PEG Ratio can also be used to compare different companies across the industry and find the best bargains.
For more information on PEG Ratio, please check our blog
If the company’s earnings are negative or had no earnings for a certain interval then earnings-based valuation methods (P/E and PEG Ratios) are not applicable.
The price to sales (P/S) ratio is another valuation method that is effective and easy to use in understanding the value of the company. P/S Ratio has more emphasis on sales or revenues generated by the company.
Price to Sales Ratio is calculated by dividing the total market capitalization of the company by its sales or revenues (P/S = Market Capitalization/Sales).
Thus, based on the future sales projection an investor can arrive at the fair value of the company.
EV/EBITDA is a popular valuation multiple used widely in the equity research. Enterprise Value (EV) is considered an alternative to Market capitalization, while Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) is the operating profit made by a company.
Enterprise Value Formula & its importance:
The components of the Enterprise Value are Market Capitalization, Debit and Cash.
The formula of Enterprise Value is Market Capitalization + Debt – Cash.
For a detailed explanation and illustration of EV/EBITDA please Click Here
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