Chapter 7: Common Stock Valuation Terms

Chapter 7: Common Stock Valuation Terms

 7.1 Different ways to analyze stocks

 

Fundamental Analysis and Technical Analysis are two common ways to analyze stocks.

Fundamental analysis is used to calculate the intrinsic value of a stock based on the financials of the company, macro-economic factors and sector outlook.  Investors use this for long-term investment.

On the other hand, technical analysis is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. It does not attempt to measure a security's intrinsic value, but instead uses charts, trend lines and other tools to identify patterns that can suggest future activity. Usually, it is used for short-term investment outlook.

 

 7.2 Market capitalization

 Market capitalization of a company can be calculated by multiplying the total number of outstanding shares with the market price of the stock.

Market capitalization = Market price X number of outstanding shares

For example, if a stock’s current market price is Rs. 150 and the company has 50 lakh outstanding shares, then the market capitalization of the company would be 150*50,00,000 = 75 crore.

Small cap, Mid cap and Large cap stocks

Based on market capitalization, stocks can be categorized as large cap, mid cap and small cap companies.

As per SEBI guidelines, the first 100 stocks in terms of market capitalization are large cap stocks, 101-250 stocks are mid cap and the rest, 251 onward, are small cap stocks.

Large cap stocks are the ideal choice for investors who are risk averse and looking for steady returns on their investment, while aggressive investors can invest in mid and small cap stocks. Large cap stocks are also known as ‘blue chip stocks.’

 

7.3 EPS (Earnings per share)

Earnings per share can be calculated by dividing the total profit of a company with total outstanding number of shares.

EPS = Net profit / number of outstanding shares

Higher the EPS of the company, higher is its profitability. But that does not mean that companies with higher earnings are good for investment. You can decide on that by comparing the price of the share to its earnings and with a peer group of companies. Usually, stocks with high EPS and high EPS growth rate command premium pricing in the market.

 

7.4 P/E (Price to earnings) ratio

Price to Earnings ratio is one of the most important parameters for stock valuation. It is calculated by dividing the market price of the stock with its EPS.

P/E ratio = Market price/EPS

For example, if a stock price is RS. 100 and its EPS is Rs. 5, then its P/E ratio is 100/5 = 20. It means that if you want to purchase this stock, you need to pay 20 times its earning. P/E ratio is a comparable parameter that can be used for comparisons with leading companies from the sector.

Let’s understand this with an example:

Assume that there are three companies: ABC, XYZ and PQR from the same sector.

 

Company name

Market price (A)

EPS (B)

P/E ratio (A/B)

ABC

100

5

20

XYZ

180

15

12

PQR

480

20

24

 

As per the above example, if we want to purchase ABC, we need to pay 20 times the earnings, for XYZ we need to pay 12 times the earnings and for PQR, we need to pay 24 times the earnings. From this data, XYZ looks better due to its cheap valuation in comparison to other stocks. But we cannot take a decision simply based on this. The stock market is always forward looking, so we also need to estimate future growth prospects of the company.  It might be that the stock that seems expensive has high growth and that is why it commands higher valuation. To understand this, we need to understand another ratio, which is known as Price earnings to growth ratio (PEG).
 

 

PEG (Price earnings to growth) ratio

Price earnings to growth ratio is another important parameter to value a stock. It not only considers the P/E ratio but also considers future earnings growth estimates of a company. If we look at P/E ratio in isolation, a higher P/E ratio may seem expensive, but if those stocks also have a higher growth estimate, then higher P/E looks justified.

If we take a decision solely based on P/E ratio, we may not always consider high P/E stocks that may be high growth stocks as well. PEG ratio can be calculated by dividing the P/E ratio by earnings growth.

PEG Ratio = P/E ratio/Earnings growth rate

If a stock has a high P/E ratio and a higher growth rate, then the PEG ratio would be lower. Stocks having a low PEG ratio, less than one, are ideally considered suitable for buying and a PEG ratio of more than one can be considered as an expensive valuation.

 

Company name

Market price (A)

EPS (B)

P/E ratio (C=A/B)

Earnings growth rate (D)

PEG ratio (C/D)

ABC

100

5

20

15%

1.33

XYZ

180

15

12

6%

2

PQR

480

20

24

25%

0.96

 

As per the above data, the valuation of PQR seems justified despite having a high P/E ratio.

 

7.5 Book value and P/BV (price to book value) ratio

Book value of a stock refers to the net worth of the stock. It can be calculated by dividing the net worth of the company with the total number of outstanding shares.
Book value can also be defined as the amount to be received by a shareholder in case the company goes for liquidation. It is a critical parameter for evaluating the stock of companies that have a huge asset and liabilities base.

Book Value = (Total Assets – Total Liabilities)/ Total number of outstanding shares

Price to book value is an important valuation parameter and helps in investment decision making.
 

P/BV = Market price/Book value

 

If P/BV is less than 1, it may seem that price is good for investment, but investors should be cautious about asset and liability quality and the values assigned to them on the books of the company. Many analysts discount the net worth of the company if the quality of assets is not up to the mark. It is advised to get a detailed analysis of book value through quality research reports instead of numbers provided by the management on the balance sheet.

 

7.6 RoE (Return on Equity)

Return on Equity (RoE) is an important parameter for evaluating the profitability of a business. As a shareholder, it is important to know how much return has been generated by a business on equity capital. RoE can be calculated by dividing the annual profit of a company by its equity capital.

Return on Equity (RoE) = Annual Profit / Equity Capital

RoE of a company can be compared with leading peer group companies. A higher RoE indicates superior returns offered by a company on its equity capital. Higher RoE also indicates better utilization of company assets by the management to create profits.

 

7.7 Economic moat

The term economic moat has been coined by legendary investor, Warren Buffet. It is related to the company’s capability to maintain its sustainable competitive advantage over competitors in the long run to protect its profits. In financial terms, a business with a moat has high free cash flows, low cost of capital and a positive return on invested capital.

As per Warren Buffet, companies with strong economic moats are more likely to be successful in the long-term as they can maintain their competitive edge.