How To Do Valuation Analysis of A Company
How To Do Valuation Analysis of A Company
How To Do Valuation Analysis of A Company
www.drvijaymalik.com/2014/12/selecting-top-stocks-to-buy-part-7.html
“Selecting Top Stocks to Buy” is a series of articles that focuses on the process of
selection of stocks for investment. Until now, we have learned about:
Part 1: Getting the right perspective towards stocks investing & the qualities
required to become a successful investor,
Part 2: Different stock picking approaches & the guidelines for selecting the
suitable stock picking approach,
Part 3: The process of shortlisting stocks for detailed analysis & various tools
available to an investor for shortlisting of stocks,
Part 4: The framework of detailed analysis of a company,
Part 5: Understanding the annual report of a company and
Part 6: Financial analysis of a company
The current article contains the details of valuation analysis of a company & its stock.
Valuation Analysis
Valuation analysis is conducted to decide whether the stock of a company is current selling
at attractive (cheap/undervalued), fair (rightly priced) or expensive (overvalued) valuations.
Valuation analysis is second level of filter post financial analysis, used to select stocks for
further analysis. Only the stocks that satisfy the criteria of good financial performance and
attractive valuations should be analysed further.
Once an investor has found a financially strong company by using the parameters
highlighted in Part 6, she should do the valuation analysis to check whether the stock of the
company is priced right.
If the shares of a company are overvalued then the investor should avoid investing in it,
however good the company’s financial position may be. Investing hard-earned money in
overvalued stocks exposes the investor to higher levels of risk where the potential of future
appreciation is limited but the risk of losing of money is high. Therefore, valuation analysis
becomes paramount before taking a decision to buy any stock.
Valuation analysis compares the stock market values of the stock of a company with its
financial parameters. Stock market values consist of current market price (CMP), market
capitalization (MCap) etc. Various financial parameters, which are used in valuation
analysis, are earning per share (EPS), sales, sales growth rate, earnings (EPS) growth
rate, book value, shareholder’s equity, dividend payout etc.
Different investors have devised many criteria to assess the current valuation levels of the
stock of a company. Some of these criteria are:
Read 3 Principles to Decide the Investable P/E Ratio of a Stock for Value Investors
Also Read: How to earn High Returns at Low Risk - Invest in Low P/E Stocks
EY takes into account the absolute value of P/E ratio. It is measured as inverse of P/E ratio
i.e. E/P. It is calculated by dividing the EPS with CMP. EY provides an idea about the
earning/returns that a stock would produce for every INR invested by the buyer in it.
If P/E is 20, then EY would be 1/20 = 5%. Many investors compare EY with Government
Securities (GSec) yield in India or Treasury yield in USA. If EY is more than GSec/Treasury
yield, then the stock is assumed undervalued and at an attractive investment as investors
would find stocks more rewarding than bonds and shift money from bonds/fixed income
investments to stocks.
10-year GSec yield in India is currently about 8%. As per above parameter, a stock should
have EY of at least equal to 8% (i.e. P/E ratio of 1/8 or 12.5) to be considered a better
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investment over bonds/GSec.
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An investor can relate DY to rental yield of a residential property or yield on
bonds/GSec/Treasury. If annual rental income is INR 2 lac (0.2 million) from a flat, which
has a value of INR 1 crore (10 million), then the rental yield of that flat is 2%. High yields,
whether dividend or rental, mean that share/flat prices are cheaper and low yields mean
that share/flat prices are costlier. Stocks with DY of >5% are considered very attractive.
However, companies that are growing very fast need to invest most of the profits for
expansion plans. Such companies prefer to declare very small dividends. I do not focus on
the DY, if the company puts the retained profits to good use.
We can find out whether the company is utilizing retained earnings to generate value for
shareholders, by comparing the amount of retained earnings with the increase in market
capitalization of the company over last 10 years. As per Warren Buffett, a company should
generate at least $ 1 in market value for each $ 1 of profits retained. This comparison is an
important parameter for assessing the management capability to generate value for
shareholders. I would discuss more about it in future article on management analysis of a
company.
CONCLUSION
In the current article, we learnt about various parameters used for doing valuation analysis
of the stock of a company in details. The parameters discussed above are simple ones and
should suffice for the basic due diligence by any individual investor.
There are many more ratios like Price to Cash EPS ratio, Cash to Mcap ratio etc, which can
be used to gain further insights into the valuation levels of the stock of a company.
However, I believe that if an investor analyses any stock on some of the parameters
discussed above before she commits to buy it, she would be able to avoid putting her hard-
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earned money in overvalued stocks where the potential of future appreciation is rather
limited and the risk of loss of money is high.
To summarize the important valuation parameters:
Price to Earnings ratio (P/E ratio): I prefer investing in financially sound companies
with P/E ratio of <10. They provide good margin of safety.
Read updates: 3 Principles to Decide the Investable P/E Ratio of a Stock
for Value Investors
P/E to Growth ratio (PEG ratio): should be <1.
Earnings Yield (EY): should be greater than long term government bond yields or
bank fixed deposit interest rates.
Price to Book value ratio (P/B ratio): should be <1. However, I find it irrelevant for
sectors other than financial services.
Price to Sales ratio (P/S ratio): buy if P/S ratio is < 1.5 and sell if >3.
Dividend Yield (DY): Higher the better. DY of >5% is very attractive. However, I do
not focus a lot on DY for companies in fast growth phase.
EV/EBITDA: It is a valuation parameter for entire stakeholders and removes the
impact of sources of funds (i.e. capital structure or debt to equity ratio).
I have compiled a list of parameters that I look while shortlisting stocks for analysis. You
may read about these parameters in the article “Investing101: Stock Picking Strategies”
In future articles on the series “Top Stocks to Buy”, I would discuss remaining sections of
detailed analysis of a company: Business & Industry and Management analysis.
I would like to have your feedback on this series of articles. It would be very helpful if you
can tell the readers about the parameters you use for analysis of companies & their stocks.
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