Valuation of a company tells us whether the stock of a company is sold at a low price(cheap), fair price(right) or high price(expensive). After fulfilling the other criteria, it’s important that the investor pays attention to valuation analysis before putting his hard-earned money in any company.
Even if the company is financially strong and its management is also great but is overvalued, an investor should avoid such company as there will be fewer chances of capital appreciation.
Although there might be no capital loss if you are invested in the great company, the main aim of earning higher return will be minimized because of paying more for owning the stock of a company.
Different investors use different parameters to determine if the stock of the company is undervalued or overvalued. Few of them are:
- Price/Earnings Ratio (P/E)
- Price/Sales Ratio (P/S)
- Price/Book Ratio (P/B)
- Discounted Cash Flow (DCF)
I will try and help you with the method which I follow and use as a valuation method to shortlist my companies.
Price/Earnings Ratio: I personally prefer P/E ratio as my valuation parameter for shortlisting stocks. It is widely used parameter to analyze whether the stock of any company is overvalued or undervalued.
It is the ratio of the current market price of a company to earning per share (EPS) of the company. It tells price the investor pays to buy Rs 1 earning of the company.
For example, if P/E ratio of a company is 20, it means that an investor is paying Rs 20 to get Rs 1 earning of the company in one year. Similarly, if P/E ratio of a company is 15, it means the investor is paying Rs 15 to get Rs 1 earning of the company in one year. From above example, it is evident that at P/E 20 investor is paying more to buy a stock.
The company should be run by great management and be financially strong. Only comparing the P/E ratio of the company and buying which is sold at low P/E ratio is a wrong way to buy stock of a company.
Margin of Safety: This concept was introduced by Benjamin Graham in his famous Book “The Intelligent Investor”. He has focused on Earning Yield which is an inverse of P/E ratio. For example, if P/E ratio of a company is 8, then EY(Earning Yield) will be 12.5(1/8).
Graham says we need to compare EY of a company with the 10 years GSec yield of a country. Higher the EY of the company in comparison with Gsec yield, the greater is the margin of safety and safer is the stock to invest in.
10-year Gsec yield in India is currently 8%, so as per above criteria, EY of a company should be at least 8% i.e P/E ratio should be 12.5% to be a safe investment over Gsec/Bonds.
How I Shortlist:
I like to buy a company which has ethical and able management with strong financials at a low P/E ratio. It’s important to remember that a poor company is always trading at low P/E multiple. Our job is to find out excellent company out of the lot.
The advantage of investing in great company available at low P/E ratio is that once it comes under the radar of institutional investors and other market participants, the price as well as the P/E ratio increases giving a great return to shareholders of a company.
I personally prefer company having a P/E < 10. I will repeat again it should be backed by great management and strong financials.
Suppose I found a great company but it is available at P/E > 10, then I will compare the Fixed Deposit Rate Of SBI for 10 Years and check how much I am ready to pay.
For example, SBI FD rate for 10 years is 7.25%, so maximum P/E ratio I am ready to pay for a great company is 13.79 (1/7.25%). In short for a great company I buy even at P/E ratio of 14. Anything above P/E ratio of 14 will be expensive for me.
Valuation of a company is a very subjective topic. Investors use different techniques to value a company. I prefer buying a company when it is unnoticed from the market, so I look for great company available at a low P/E ratio.