Stock valuation is one of the most important aspects to analyze before investing in any share. You might be able to find a good company, however, if you not evaluating its valuation correctly and entering at an inflated price, then it might turn out to be a bad investment.
“A great company is not a great investment if you pay too much for the stock.“ - Benjamin Graham
In this post, we'll discuss how to do stock valuation using the relative valuation of stocks approach.
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Basics of Stock Valuation
There are two basic approaches to find the valuation of
stocks:
1) Absolute Valuation Approach 2) Relative
valuation Approach.
The absolute valuation tries to determine the intrinsic value of the company based on the estimated profits and free cash
flows discounted to their present value. The Discounted Cash Flow model (DCF)
is the most common approach for absolute valuation.
However, the major
limitation of using absolute valuation is that the results are only as good as
inputs as you will require to make many assumptions. You can read this post to
understand absolute valuation.
Relative Valuation of Stocks
Relative valuation of stocks is an
alternative to absolute valuation. It is an easier approach to determine
whether a company is worth investing in or not. Relative valuation compares
the company’s financials to that of its competitors and industry average (or
historical performance) to find the company’s financial position.
Tools to Perform Relative valuation of stocks
A few of the most common
financial ratios that you should definitely know to perform a relative
valuation of stocks are described below:
1. Price to earnings (PE) ratio
A high PE ratio generally shows that the investor is paying more for the share. As a thumb rule, a company with a lower
PE ratio compared to its competitors is considered under-valued compared to
another company in the same sector with a higher PE ratio.
2. Price to Book Value (PBV) Ratio
The book value is referred to as the
net asset value of a company. PBV ratio is an indication of how much
shareholders are paying for the net assets of a company. Generally, a lower
PBV ratio could mean that the stock is undervalued.
3. Price to Sales Ratio
The Price to Sales Ratio (P/S) ratio measures the
price of a company’s stock against its annual sales. As a thumb rule, a lower
P/S ratio compared to the other companies in the same industry means that the
stock is comparatively undervalued.
A few other popular financial tools that you can use to perform the relative valuation of stocks are PEG Ratio (Price to Earnings to Growth Ratio), Dividend Yield, Price to Free Cash Flow, etc.
Conclusion
Relative valuation of stocks is a good alternative to absolute
valuation. You can use this approach for a simple yet effective stock
valuation can comparison.
That’s all for this post. I hope it was
useful for you. Do let me know if you have any questions related to the
relative valuation approach by simply write in a comment. I’ll be happy to
help.
Have a great day and Happy Investing.
