Guide To Investing In Stock Market (Part VIII)

Valuation And Valuation Techniques

Valuation of a company is to determine the value of a company at a price. To an investor, who is not a trader, a company should generate returns that not only keep it in business but also generate returns for their investments. Amidst all fluctuations and volatility any stock will finally stabilize at its fundamental value. Valuation can be classified into two categories: Relative Valuation and Absolute Valuation using the Discounted Cash Flow (DCF).

Relative Valuations are used to value companies, which have Secular businesses

1. Earning Per Share (EPS)
2. Price To Earnings (P/E)
3. Price To Earnings growth (PEG)
4. Price To Book Value Ratio

EPS is PAT divided by the no of shares issued. It is the most common measure to value a company, but since it says nothing about the cost of generating these profits, it should not be used as a valuation technique for businesses which though secular may be in an investment mode or a growth phase

P/E is calculated as the market price of the stock divided by the EPS. It states the price that has to be paid to invest in a company with a given level of earnings. A high P/E indicates an already high value perceived by the market. A high or low value of P/E is determined by comparing it with companies of similar, if not same, business and size.

P/E/g is calculated as the P/E divided by an anticipated growth in the earnings. As P/E multiple is envisaged to mirror earnings growth. This ratio for a fully valued company ideally is perceived to be 1 or close to 1. For a value less than 1, it implies that the P/E has not mirrored the growth and there is still some scope.

EV/EBITDA: EV (Enterprise Value) is a sum of the market capitalization and debt less cash and equivalents and EBITDA is the operating profit, before deducting interest, depreciation and tax. This is similar to calculating a P/E and is used in cases, where a secular company is in expansion mode.

EV/Sales: This ratio should be used for comparing companies, which are secular, having similar margins and similar business models. The only differentiating factor amongst these companies is therefore the sales numbers. A typical example could be companies in organized retail.

Return on Capital Employed (ROCE): This is calculated by dividing the EBIT (Earnings before Interest and Taxes) by Capital Employed, which is the sum of the book value of equity and the book value of debt. For companies that continuously need capital infusion or which are highly working capital intensive and the only differentiating factor amongst them is their ability to generate better returns on additional capital infused, a growing ROCE is considered to be good. Engineering companies can be a good example for using this technique.

Absolute Valuations are used to value companies, which have negative earnings, are cyclical companies, are in the process of restructuring or are in the investment mode. The DCF methodology advocates valuation of a company based on the present value of the future free cash flows that a company is expected to generate.

As can be seen above, there are multiple ways to value a company and every technique is uniquely used in different cases. The underlying basis of valuation is not the techniques, but is the understanding of the value to be created in terms of earnings or future cash flows and therefore, valuation is not pure arithmetic. The crux of the matter is the true understanding of the fundamentals of the business and the appropriate understanding of the future growth potential of a company.