How to do Valuation Analysis of a Company

Modified: 09-Aug-20

The current article contains the details of valuation analysis of a company & its stock. The article also contains answers to some of the important queries related to valuation analysis & different ratios asked by investors.

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:

 

Simple Steps to do Valuation Analysis of Stocks

1) Price to Earnings Ratio (P/E ratio)

P/E ratio is the most widely used parameter to analyse whether the stock of any company is overvalued or undervalued at any point of time. It is calculated by dividing the current market price (CMP) of a stock by profit/earnings per share (EPS). It represents the price an investor pays to buy INR 1 of earnings of a company.

If P/E is 10, it means that to get INR 1 of earnings in one year from a company, the investor is paying INR 10. Similarly, if P/E is 20, it means that to get INR 1 of earnings in one year from the company, the investor is paying INR 20. If we compare P/E ratio of 10 and 20, in the above example, it would become evident that at P/E of 20, the investor is paying more money to get the same value of INR 1 in earnings than when P/E is 10.

Investors interpret P/E ratio and its derivatives in multiple ways to decide about valuation level of a stock: 

  • Comparing P/E ratio of the stock with the industry in which the company operates: Industry P/E ratio is the average of P/E ratios of all the companies of the specific industry listed on the stock exchange. If P/E ratio of the stock is higher than the industry P/E ratio, it is assumed to be overvalued and vice versa. 
  • Comparing current P/E ratio with historical P/E ratio of the stock: if P/E ratio is lower than average P/E ratio of last 10 years, then stock is deemed undervalued and vice versa. 
  • Comparing P/E ratio with earnings (EPS) growth rate (PEG ratio) as described below and 
  • Comparing P/E ratio in form of Earnings Yield (EY) with yield on other asset classes like government securities (GSec), Treasury Bills etc. as described below.

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

Also Read: Hidden Risk of Investing in High P/E Stocks 

 

2) P/E to Growth Ratio (PEG Ratio)

PEG ratio compares the P/E ratio with the growth rate of earnings (EPS) of the company. The underlying assumption is that a stock can command a P/E ratio, which is comparable to the growth rate of the earnings of the company i.e. a company that is growing its earnings at 25% yearly should have a P/E ratio should be about 25. 

PEG ratio is measured by dividing P/E ratio with the earnings growth rate (PEG ratio). If P/E ratio is less than the growth rate of the earnings of the company i.e. if PEG ratio is less than 1, the stock is assumed to be undervalued and vice versa.

 

3) Earnings Yield (EY)

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 investment over bonds/GSec.

 

Margin of Safety (MoS): 

The concept of MoS by Benjamin Graham is based on EY. Graham says that the higher the difference between EY and GSec/Treasury Yield, the safer is the stock investment. 

To illustrate, suppose the investor buys a stock of company ABC Ltd at INR 100. If EPS of ABC Ltd is INR 10 then P/E ratio would be 10 and the EY would be 1/10 or 10%. As current GSec yield is 8%, ABC Ltd is a good investment. Suppose, after the investor buys ABC stock, its price falls and become INR 50, then the P/E ratio would become 5 and the EY would become 1/5 i.e. 20%. EY of 20% would attract more and more investors to shift money from bonds markets and use it to buy ABC stock as it yields 20% against GSec yield of 8%. This new demand for ABC stock will increase its stock price and limit the downfall. Herein, Graham says that higher the difference between EY and GSec/Treasury yield, higher is the Margin of Safety.

I prefer stocks with P/E ratio of less than 10 as they offer a good margin of safety. Also Read: 3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of Stock Investing

 

4) Price to Book Value Ratio (P/B ratio)

P/B ratio is calculated by dividing the CMP of a stock with the book value (shareholder’s equity + retained earnings) per share. It represents the price an investor pays for INR 1 of the net assets of the company after settling all its outsider’s liabilities.

P/B ratio of 1 means that the investor is paying exactly the money that the assets are in company’s records. P/B ratio of 2 means that one is paying double the amount that the assets are in company’s records. Higher book values mean costlier valuations of the company. Stocks with P/B ratio of less than 1 are considered undervalued and vice versa.

I find P/B ratio irrelevant due to usage of historical cost of company’s assets while calculating the book value. The historical cost might not represent the current market value of company’s assets. However, P/B ratio is very important for companies in financial sector where most of the assets are cash assets and book value is good indicator of net worth of the company.

Benjamin Graham said that an investor should look for companies where P/E * P/B is < 22.5. However, I focus mainly on companies with P/E <10 while ignoring P/B ratio.

 

5) Price to Sales Ratio (P/S ratio)

P/S ratio was used by James O’Shaughnessy. It is calculated by dividing CMP of a stock with sales per share of the company. It effectively compares the MCap of the company with its annual sales. If P/S ratio of a stock is <1.5, then the stock is considered undervalued. O’Shaughnessy advised investors to sell the stock once its P/S ratio exceeds 3.

 

6) Dividend Yield (DY)

DY is a measurement of dividend paid by a stock compared to its market price (DY = dividend paid/CMP). If a company with CMP of INR 100 pays a dividend of INR 2 per share in a year, then its DY is 2%.

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.

 

7) Enterprise Value (EV) to EBITDA Ratio (EV/EBITDA)

Enterprise value (EV) of a company is calculated as Equity + Total Debt – Cash & Equivalents. It is a measure of all the funds employed by a company in its operating assets irrespective of their source i.e. whether own or borrowed funds. We deduct cash & equivalents as they represent the excess assets, which are not deployed in the operations of the company yet. Cash investments provide interest/investment income, which is non-operating income for the company. An individual investor should use market capitalization (MCap) of the company in place of Equity in above formula to arrive at current EV of the company.

EBITDA stands for earnings before interest, tax, depreciation and amortization. EBITDA is a measure of the amount of profits that are pertaining to all stakeholders in the company including shareholders, bondholders or lenders.

Further Advised Reading: Can we compare EBITDA with CFO to assess quality of profits?

EV/EBITDA is a measure of analyzing the valuation level of companies that does not factor in the capital structure (debt to equity ratio) of the company. 

Interpretation of EV/EBITDA is similar to P/E ratio. What P/E ratio is for equity holders of a company, EV/EBITDA is for all stakeholders (shareholders, bondholders & lenders put together) of the company. Low EV/EBITDA ratio represents undervalued company and vice versa.

EV/EBITDA is mainly used by investors when they plan to buy entire companies rather than investing in small number of stocks. However, it still has its relevance for equity investors.

 

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-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:

  1. 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. 
    1. Read updates: 3 Principles to Decide the Investable P/E Ratio of a Stock for Value Investors
  2. P/E to Growth ratio (PEG ratio): should be <1. 
  3. Earnings Yield (EY): should be greater than long term government bond yields or bank fixed deposit interest rates. 
  4. Price to Book value ratio (P/B ratio): should be <1. However, I find it irrelevant for sectors other than financial services. 
  5. Price to Sales ratio (P/S ratio): buy if P/S ratio is < 1.5 and sell if >3. 
  6. 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. 
  7. 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

Let us now address some of the important queries related to valuation analysis asked by investors.

 

Do we calculate Intrinsic Value / Fair Value / DCF for a Stock?

Hi Vijay,

I was recently reading an article titled “The Super investors of Graha-Doddsville”. In that he says when talking about Walter Schloss that he doesn’t really try to estimate next quarter or year earnings.

Rick Gurien also asks the question how much is the business selling for and how much is the business worth (value). They always look for gaps in price and value.

In the same article, Buffett says that when Washington Post was selling at $80m where as it was worth $400m. He says that it is the intrinsic value (IV). I generally read he rarely reveals the intrinsic value. I also know that he doesn’t use DCF.

Now I collected the 1971, 1972, 1973 annual reports. I don’t know how he has arrived at an intrinsic value of $400m. All I can see is $160m in assets on the balance sheet (in 1972). Unless he has realized that there is some land/property which was quoted at historic prices and he had rough idea of what they were worth actually in 1972 (which I doubt), I feel he should have still used some projections. Or maybe I am missing something in those balance sheets/Annual reports.

I know this topic may not be any interest to you, but I wanted to see if I there is a way to estimate and see if I can get close to the same intrinsic value and hence the lessons learnt from the exercise can be applied to my own investing.

Can you please point me what to look for in those annual reports?

I have already looked at the things that are obvious. I just googled and got all the reports and the 1984 article. Let me know if I have to send them on your email.

Thanks

Similar Query:

I want to solve my problem of calculating the fair value of a stock.

We invest in stocks today in the view of future increase of its stock price. In other words, we are expecting its future earnings to grow. (Assuming we have already made a decision on company A)

  1. Let’s say Company A at Rs 100 stock price is growing 10% every year till yesterday. At their annual results update, they are giving a guidance of 15% for next year. So keeping this in mind, the ideal price for this stock by end of the next year should be 115. So, for some reason if the stock price goes up to 115 the very same day or in a month. Can we safely say the stock price is currently priced in the earnings for next year? And therefore a good time to exit? (Assuming Company A’s fair value is 100)
  2. For some reason, the price tanks by 20% to 80. Then given the guidance of 15% from the company and looking at past growth of 10% at the minimum, Can I assume it’s available at a discount?

I may be going by the guidance of the company but that’s just taking into some past and relatively moderate future expectations of the company.

If my above assumptions are correct then I am interested in finding the fair value. Can u pls help me arrive at a simple valuation formula which is more or less closer to the intrinsic value of the stock?

Author’s Response:

Hi,

Thanks for writing to me.

We am happy to see the efforts you are putting in assessing the value of a stock. It is commendable that you dug deeper into Buffett’s assessment of business value and read the past annual reports of Washington Post.

Unfortunately, we would not be able to help you in arriving at the intrinsic value / fair value of Washington Post ($400m). There are many reasons for it:

1) We do not try to assign any definite intrinsic/target value to a company. Buffett might have used some projections or any of his own valuation technique. However, we believe that it is very difficult for me to tell anyone including myself that the company is worth “X” amount of money. Economic environment keeps on changing constantly and any of the assumption/projection devised today is bound to be proved wrong tomorrow.

We may find many such examples in Indian markets as well, where companies thought to be darlings of investors did not perform. Management guidance prove wrong almost all the time and almost every time managements have plausible reasons to convince investors why they are not able to meet guidance. Whereas the actual reason is that the management had expected certain economic environment, which did not pan out as they had expected, which no one can predict.

While investing, we try to find out a management which has reflected in its actions until now that it is a competent & shareholder friendly. And if we find that this management is running a business, which is not cash guzzling, then we buy the stock. We buy it with a faith on the management that they will keep steering the company through future changing scenarios and we as minority shareholders would benefit by being a partner with them.

Buffett might have his own assumptions to arrive at $400m value to Washington Post from the annual report, if he did so, but we believe that Washington Post would not have generated good returns for him if the management was not competent. If without assessing management, his assumptions came true, then we would say that Buffett was plain lucky.

You may read about the parameters for assessing management in the following article:

How to do Management Analysis of a Company

Therefore, we advise reader to look at the past performance of the company and at current stock price to assess if the company has margin of safety and then decide to invest or avoid. An investor should rely on future guidance.

One may read about calculating margin of safety of a stock in the following article:

3 Simple Ways to Assess “Margin of Safety”: The Cornerstone of StockInvesting

2) Currently, due to paucity of time, we would not be able to devote time to reading these balance sheets.

Once again, we appreciate your efforts to improve your stock investing skills by analysing the stock picking approach of great investors. You are taking good initiatives to learn the skill.

All the best for your investing journey!

Regards,

Vijay

 

Investors’ Queries: How to do Valuation Analysis of Stocks?

What is the right price to pay for a good stock?

I completely agree with your analysis of Atul Auto Limited and Amit Gupta who carried out a deep dive and sound research. Atul Auto Limited is a great company. I had this company on my radar for quite a few months.

Read: Analysis: Atul Auto Limited

The one question which is paramount is:

What is the right price for a stock or for Atul Auto Limited? Atul Auto Limited has given a 1:1 bonus. The stock was at ₹800 and then the bonus brought it to half price – which is perfectly ok

We all face this challenge: MRF Limited is a great company, Alkyl Amines Chemicals Limited is awesome, Supreme Industries Limited is fabulous but what is the right price to venture into a stock. Even if we keep accumulating on dips, how do we left the price?

Like Warren Buffet says:

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

So my question is: we are on the same page that Atul Auto Limited is a great company, excellent management, strong fundamentals, and good return to investors but is it worth to buy the stock at this price or wait for a correction. Since we are long-term investors, we are not looking at buy today & sell tomorrow or same day trading.

What is your suggestion?

Author’s Response: 

Thanks for writing to me! Without doubt Amit has done a very good job in his analysis of Atul Auto Limited from different perspectives.

As far as buying price of Atul Auto Limited or any other stock is concerned, every investor has a different take on it. I would be happy to elaborate on my purchase price criterion.

I believe in following the criterion set by Benjamin Graham in his book Intelligent Investor. Graham defines margin of safety as the difference by which the earnings yield of a stock is higher than the long term treasury rate. As the G-sec or comparative Bank FD rates in India are currently about 9-10%, therefore it amounts to a maximum P/E of about 10-11. This P/E criteria would keep getting a bit relaxed as the interest rates fall. However, there are other parameters contributing to the margin of safety, which lead to an investor willing to pay certain premium for good stocks.  However, the lower the P/E the better. You may read the following article to know about the ideal PE ratio that we are willing to pay for any stock:

Read: 3 Principles to Decide the Ideal PE Ratio of a Stock for Value Investors

Many readers have commented that I might be missing out on a lot of potential growth opportunities by the strict P/E criterion. Many other investors (like Prof. Sanjay Bakshi) have recommended to pay for growth upfront in terms of higher P/E. However, as I mentioned previously, every investor has her own criteria for deciding the purchase price.

I have made a checklist for buying stocks, which I follow before deciding to invest in a stock. You may read about this checklist in the following article:

Final Checklist for Buying Stocks

Hope it clarifies my criteria for deciding the buying price level of Atul Auto or any other such stock. I suggest the investors to keep waiting until she finds the fundamentally sound stock trading at attractive valuations. She should not become impatient and buy stocks without margin of safety.

It would be good if you could share your criterion for deciding the buying price of any stock with the author and the readers of this website. It would be helpful for everyone.

All the best for investing journey!

Regards,

Vijay

 

Similar Query: How to decide about the buying price of any stock

Dear Vijay,

Firstly, I want to thank you for the wonderful work you have done on your website, it the best website that I have come across till date on stock market for common investor.

I have few queries:

  1. Please could you define in simple term/formula/tip by which we can determine right price (entry/valuation price) of a stock? I am very keen on buying Mayur Uniquoters Limited & Vinati Organics Limited.
  2. In layman terms would prices close to 52week low, serve as an entry price for a new investor?

I had bought Indag Rubber Limited on Aug 24, 2015 when it fell x% and plan to buy it on dips going ahead.

I plan to invest as a long term investor 5-8 years in line with my personal goals.

I like your portfolio and doing my own analysis before making a decision.

Many thanks in advance,

Author’s Response:

Hi,

Thanks for your feedback & appreciation! I am happy that you found the articles useful!

You may find the steps to do arrive at the ideal PE ratio for investment in the following article:

3 Principles to Decide the Ideal P/E Ratio of a Stock for Value Investors

This article would help the readers in forming an opinion about the current valuation levels of any stock.

  1. 52 week or 52 week high price levels are irrelevant. I suggest that investors should have opinion about valuation levels based on current price irrespective of it being near 52 week high or low.

There might be stocks which are attractively priced despite being at 52 week high and there may be stocks which are still costly despite being at 52 week low.

Reading the above article on valuation analysis would help you decide about the current valuation levels (overvalued, undervalued or fair valued) of a stock.

Regards,

Vijay

 

Can we identify the right time to invest in a stock?

Hi Vijay

Thanks for the reply. I’m a beginner and want to understand more about how to identify right time to enter a stock?

Let’s say, I find Ambika Cotton Mills Limited an attractive option to invest for its strong fundamentals & YOY growth but if I entered 1 month before my holding will be almost -35% now. To get back to my invested money now Ambika cotton mills have to grow approx. 53% from CMP. So, I understood finding out bottom value for stock is very important andI  would like to know more from you on this.

Also. I would like to know your views whether an investor need to average their stock in every dip? Even to do so finding out how much the stock can possibly break to lowest is an important thing again.

Author’s Response:

Hi,

Thanks for writing to me!

The right time to invest in a stock is: whenever the investor has surplus money to invest and the stock is at attractive valuations.

No one can tell the bottom a stock price will touch before it bounces back. Therefore, if an investor believes that a stock is a good buy below the investable P/E ratio, then she should invest when the stock fall below the investable P/E ratio and she has money to invest.

Read: 3 Principles to Decide the Ideal P/E Ratio of a Stock for Value Investors

No one can predict market price movements and it can happen in all probability that post her purchase, the price can fall further 50-60-80%.

However, in such a scenario, if the investor has done hard work before selecting the stock, then she would have the confidence to remain invested through such bear phase. If her confidence is shaken by stock price decline and she starts to question her analysis and stock selection, then it would mean that she needs to develop her stock selection and emotional stability further to be a successful stock market investor.

I would suggest that such investor, who panics by stock price declines, should stay away from stock markets.

You should read: Getting The Right Perspective towards Investing

Hope it helps!

Regards,

 

Which EPS to use in PE ratio and PEG ratio calculations?

Do benchmarks of PE ratio cited by Benjamin Graham apply in India?

Hi Dr,

I am new to value investing and currently following your step by step analysis approach towards my investment career. I have a few queries on the valuation analysis done by you:

  1. Regarding PE Ratio: Screener uses the last reported EPS for calculating PE Ratio. But other websites uses TTM (trailing twelve months) earnings. Which PE Ratio must we consider during valuation?
  2. PEG Ratio: Can you please give me details about how you have calculated PEG ratio, because most websites take EPS growth estimate. How are you calculating it?
  3. You have given reference to PE Ratio of <10 mentioned by Benjamin Graham in his book “The Intelligent Investor”. I am reading this book and Graham has mentioned PE ratios between 20 and 25. What does he mean by these in his book?

Author’s Response:

Congratulations that you have started reading Benjamin Graham! You have started on the right track. All the best!

1) PE ratio: Each of the websites and similarly, each of the investors has her own preferences. I use TTM (trailing twelve months) earnings but with a pinch of salt if there is a sudden jump in recent earnings.

Warren Buffett takes average earnings of past few years.

Read here: “8 Investing Lessons from Warren Buffett’s Letter of 1977

2) PEG ratio: Whenever, I use PEG ratio, I use growth rate of EPS achieved in the past.

3) P/E ratio threshold is a factor of margin of safety: Graham uses P/E ratio of 20-25 because during those times in US, the govt. bond rates were in range of 4-5%. I have elaborated on Margin of Safety in the following article:

How to earn High Returns at Low Risk – Invest in Low P/E Stocks

Reading the above article would help an investor in understanding that during low interest rate scenarios, the P/E ratio that provide a margin of safety, moves up.

Hope it helps!

Regards,

 

Use of DCF and PEG ratio in “Peaceful Investing” approach

Hi Doctor,

Just curious, do you even use the DCF method by taking a base case scenario for growth rate. After all valuation is more about the free cash flow generated than the earnings.

Additionally do you calculate the trailing PE for PEG ratio as it will be a much precise measure for valuation?

Regards

Author’s Response:

Thanks for writing to me!

I do not use DCF for valuation. I believe that every investor has her own way of arriving at value. As rightly mentioned by you, many investor use DCF to assign a fair value to any stock. However, I do not assign any such value to stocks, which I plan to invest.

I try to gauze whether the particular company has the potential to grow in future and if yes, then is it currently available at a price which can give a margin of safety. If these criteria are met and the management impresses me by way of their past actions & behavior, then I find such company to be a good investment candidate. I do not try to put any particular number to the potential level to any stock and rise or its fair value.

Read: Final Checklist for Buying Stocks

I use trailing P/E for calculating PEG ratio.

PEG is one of the criteria that is used by many investors to judge the valuation level. I do not put very high focus on it as I give absolute P/E a lot more weightage in my assessment. If PEG is <1 for a company growing at 25% CAGR and available at trailing (TTM) P/E of 20, then I might not be interested in investing in it as P/E of 20 is not giving me any margin of safety. I would love to invest in a company with 25% CAGR but only if it is available at P/E of <10 which gives a margin of safety.

Regards,

Related Query: Use of “Fair Price” in valuation:

Hello, Mr. Vijay

Sir, I am currently in learning phase and this is my first stock valuation. Your blog has been extremely helpful to me. Please point out any mistake, if I make, during the process.

The theory which has most convinced me about stock valuation is that Stock price, or market cap, is a sum of present values of all future cash flows and current book value. Considering Atul Auto Limited TTM EPS of ₹18 and assuming a cautious EPS growth of 15% for next 10 years (in last ten years EPS [email protected] 26% and in last 5 years @ 49%), terminal growth 3% for 15 years (assumed as long term inflation) and book value of ₹60, the current fair price works out to be ₹606.

What is your view on above valuation?

Author’s Response:

Hi,

I do not use the discounted cash flow (DCF) model for valuation (which you have mentioned as present value of all future cash flows). Future is always uncertain. Moreover, the present value in case of DCF would change by a huge margin by small changes in the assumptions.

Therefore, I do not have any view on the value arrived using this method.

Regards,

Vijay

 

Queries on Parameters of Valuation Analysis

Dear Dr. Vijay,

At the outset I appreciate your article on valuation analysis. The difficulty is we will not get quality businesses at cheap valuations in a normal market.

Here are some thoughts:

  1. Absolute value of PE does not reveal much and hence keeping a limit for PE like 10 may not be appropriate. For ex: HDFC Bank always commands PE of 20 to 30 since it has always grown at 30%. Its NPA level, management quality, risk control measures, NIM, RoA etc. ensure that it gets higher PE in the market. It is impossible to get such quality businesses at PE below 10.
  2. PEG theory is a very simplified approach though it correlates to growth in earnings and is better than PE alone. However, PEG=1 for fair valuation is also difficult to apply since high quality companies always get premium valuation and quote at PEG of 1.5, 2 or 3. For ex: Great businesses like HUL, Nestle, and Asian Paints etc. always command high PEG.
  3. Earnings yield considering future growth is a better approach. Earnings yield presently may be below 8% but if it achieves it in next 2 to 3 years, then the valuation can be considered attractive. However, if a company requires 5 years or more to achieve an earnings yield of 8%, we can say that stock is overvalued.
  4. Intrinsic value suggested by Warren Buffett, John Burr Williams is good but applies only to secular growth companies where future earnings can be predicted for 10 years or so. However, here the difficulty is in assuming second phase growth rate (normally taken as 5%).

These are my views. Would like to know your views also on above thoughts.

Author’s Response:

Hi,

Thanks for writing to me! I appreciate the time & effort put by you in writing your view which are helpful for the author and readers of www.drvijaymalik.com

I am happy that you have shared your inputs on the views presented by me in the article above. I would be happy to provide my views on your comments, as requested by you, however, I would like to delineate a belief that I hold about investing:

“There is no one path to success in stock market investing. Investors have made money in markets by following high P/E growth investing, low P/E value investing, and mix of both, arbitrage, technical investing, large cap investing, mid/small cap investing and many other such approaches. Therefore, I believe that there is no single standard path to succeed/make money in markets. The path an investor should follow is the one she is convinced with and feel comfortable with.”

Now let me provide my views on your comments:

  1. You are right that good business may not be available at a P/E<10. An investor is free to invest in businesses with high P/E if she is comfortable. However, I believe in investing fundamentally sound companies which are yet to be recognized by the markets, which I believe are present in the segment targeted in the above article. I agree that such opportunities are not aplenty, however, I believe that an investor does not need to find dozens of good companies. My experience in markets says that finding one company in a year is enough.

Stock investing to me is a treasure hunt and I love treating it that way. Finding fundamentally sound companies at mouthwatering valuations is like finding needle in a haystack and it requires equivalent effort. I have experienced that such companies if found at low P/E and invested early in their life cycle, then they have the potential of creating significant wealth for investor. You may read about my experience of investing in low P/E companies in this article:

How to earn High Returns at Low Risk – Invest in Low P/E Stocks

Nevertheless, there is no one path to success in markets and therefore, if an investor believes in investing high P/E companies, which are valued fairly, then she should invest in such companies without any second thoughts. Investing methods are personal choice.

  1. Part of the response to this comment is already included in the response above. I believe that if an investor follows my checklist of sales growth >15% and P/E <10 religiously for screening stocks, then PEG ratio becomes irrelevant as all the selected stocks would have PEG <1.

Read: Final Checklist for Buying Stocks

3&4: I do not rely on future projections. I believe in associating myself with a sound management running a fundamentally good company and riding the investing journey with them. I try not to project earnings 5-10 year down the road. Therefore, I do not use any parameter for analysis based on future values. However, again like I said above, it is personal choice of investors to use any parameter she is comfortable.

Therefore, if an investor believes that she can predict with reasonable certainty, the future, then she can always use future values for analysis. After all, it’s her own money and she is free to invest it as per her choice. As is said, many roads lead to Rome.

As requested, these are my views. In case, any further clarity is needed, then I would be happy to provide further elaboration.

Once again I appreciate the time & effort put in by you for sharing your views. Thanks!

Regards,

Vijay

 

Is P/B ratio with adjustments for market value of assets a better parameter?

This is very useful information, Vijay. Thank you for putting it together in an easy to understand the manner and highlighting the important valuation metrics. I just found out about your blog and there is so much to explore.

On P/B ratio, you mentioned that you don’t consider it (except for financial firms) since the book value of assets is measured on historical cost basis (I think it is as per accounting rules) and it may not represent the current market value of the assets. However, if P/B ratio is at an attractive level, say ~1 then if we adjust the book value of assets to reflect the current market value than isn’t it even better?

Author’s Response: 

Thanks for your feedback! I am happy that you liked the article.

You are right that if by any metric, we are able to adjust the book value to reflect current market value, then it would be better.

Every investor uses her own judgment to assess the current market value of the assets of a company. In effect, the current market capitalization is the judgment of entire market for current market value of the net assets of a company.

I do not use P/B as an important metric because I have not come across any reliable methodology to find current market value of company’s assets. In case you use any such methodology then it would be great if you can share it with us. It would be a good learning for me as well as other readers of the website.

Regards,

 

Do we consider average P/B ratio of a large number of stocks to determine market valuations?

First of all, when somebody says that market PE is this much, it means that they are talking about nifty, which itself is not the best indicator of the market.

As an amateur investor even I looked at these numbers. However, they did not give me exact evidence of market crash until I gathered data of various companies and did analysis.

I gathered data of top 300 companies (average transaction value wise) and found that whenever their average price to book value ratio (PB ratio) was above 4, market would crash. Average price to book value of these 300 stocks went as low as 1.79 after 2008 market crash. On 14th December average price to book value was 4.8.

Guess what? We will see market crash soon. I will not be surprised if average P/B of these 300 stocks become less than 2.5.

I have exited equities.

Author’s Response:

Hi,

Thanks for sharing your experience, learning and one of investment parameters with everyone.

Being a bottom-up investor, we do not give much weight to market/industry P/E ratio while making our investment decisions and advice the readers to ignore the macro parameters and focus more on stock specific factors for investing.

Read: Final Checklist for Buying Stocks

All the best for your investing journey!

Regards,

Vijay

 

How to value a loss making company?

Dear Sir,

I want to know that how to a value loss making company like United Spirits Limited (USL).

For example, when we use price to sales (P/S) ratio for a loss making company, the fair value arrived for USL is Rs 1,800. But my concern is that the company has been making profits for last three quarters. Total EPS is Rs 18 so if we see P/E, it’s available at 100 P/E, so I am confused now.

Please help me out, how to solve this problem?

Similar Query:

Sir, how do you value a company, if it’s making stringent losses for consecutive years? Because of its losses, its share price gets beaten down. Would you like to buy that company in such situation hoping a turn around and do you like to buy “net-nets”, which are trading at 1/3rd of their working capital?

What about buying beaten down sectors like power, infra, metals, oil & gas?

Author’s Response:

Hi,

Thanks for writing to me!

We do not believe in investing in loss making companies or turnaround stories. Similarly, we do not look for asset plays or “net-net” investing.

We look for companies which are growing at a good pace with sustained profitability and are conservatively financed with proven management competence.

You may find our criteria for stock selection in the following article:

Read: Final Checklist for Buying Stocks

All the best for your investing journey!

Regards,

Vijay

 

What does PE ratio based on future earning mean?

Hello Vijay,

Your blog is really very helpful for new investors for like me.

I have a question, while reading below analysis statements, I am unable to interpret the below:

When a report says stock trades at 30.6x FY18E, what does it exactly say, is it like it would be 30 PE or it Earnings yield and how is it calculated. I know it may a very basic question, but could you please help me on this.

However the stock trades at 30.6x FY18E earnings and we would advise to wait for better buying opportunity. We retain HOLD with revised target price of Rs 229.

Author’s Response:

Hi,

Thanks for writing to me!

30.6x FY2018E means that the current stock price is 30.6 times of the earnings that the analyst expects the company to earn in FY2018.

Regards,

Vijay

P.S.

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