Now you know the different type of shares available in the stock market. But you might be wondering, why would the company’s owners be ready to give up their ownership rights, have strangers vote for critical matters concerning their company and share their profits? The answer is quite simple – funds! As a company grows, it needs more and more funds to finance its expansion and growth plans. There are two paths it can take – debt financing or equity financing.
- Why Do Companies Need to Issue Shares?
- What is Stock Valuation?
- Absolute Valuation Method
- Relative Valuation Method
- Price /Book Value
Why do companies need to issue shares?
In debt financing, companies basically take a loan (either from financial institutions or by issuing bonds). They need to re-pay the borrowed amount along with interest to the lenders. In the equity financing, companies give up a part of their ownership by issuing shares. One major advantage of taking this route is that companies do not need to pay any fixed interest and can rather share their profits (in the form of dividend), basis for their financial and growth plans. Moreover, there is no maturity date upon which the company needs to repay the principal amount to the investors.
But it is not a one-sided love affair. Rather equity financing can be a win-win situation for both the parties – issuing company as well as investors. When the company does well, investors receive higher dividend payouts and the value of their investment appreciates. As a result, they stand to make a substantial gain by selling their stocks in the secondary market.
What is stock valuation?
Wealth creation is as much science as an art. Investing in the right stocks can truly change your fortunes. But one of the most common concerns for a lot of investors is to understand the stock’s real value. Stock valuation is the process of determining the stock’s true or intrinsic worth. The criticality of this valuation is due to the fact it is not derived or has any attachment to the current market price. If you are able to ascertain the stock’s true value, you would be able to easily determine if the stock is under-valued (a steal deal) or over-valued (waste of your money). Ultimately, it would help you to make well-thought-through and informed investment decisions, which are in the best interest of your hard-earned money.
But the question arises, how are stocks valued? If you find scratching your head, continue to read as we de-mystify the process.
There are two ways of stock valuation:
1) Absolute Valuation Method
In this valuation method, the calculation of the stock’s intrinsic value relies heavily on the fundamental financial information available about the company. Such information is accessed from the company’s financial reports, etc. They take into account aspects such as cash flows, growth rates and dividend payouts.
The two methods used for absolute valuation are:
i) DDM (Dividend Discount Model)
This model is based on the premise that the stock’s value is equivalent to the present value of the company’s future dividend payouts. This calculation remains applicable only in cases where the company distributes dividend on a regular and stable basis.
ii) DCF (Discounted Cash Flow Model)
This model follows the theory that the intrinsic value can be calculated by discounting the future cash flows of the company. This method of valuation can be used for companies with unpredictable or irregular dividend distribution.
2) Relative Valuation Method
Albert Einstein laid out the theory of relativity. Little did anyone know, that the concept would apply to stock market investment as well. Relative valuation stresses on the fact that investing in a particular stock is a choice that is not made in silos. Hence, to determine a stock’s value, you need to compare certain critical aspects with other similar companies. It takes into account financial ratios to determine the relative worth of stock.
Some common ways of relative or comparable stock valuation are:
i) Price Earning (P/E) Ratio
The P/E Ratio enables you to determine the stock’s value in relation to the company’s earnings. In simple terms, it shows you the number of years it will take for you to recover your investment, provided there is no change. A higher value can be interpreted as the willingness of investors to pay a higher price today basis the progressively larger growth expectations in the future. It is calculated as:
P/E Ratio = Market value per share divided by Earning per share
However, do remember this caveat – if you are using the P/E Ratio valuation method, make sure that the comparison is between similar sectors, markets or industries.
This ratio is also sometimes referred to as the earnings or price multiplier.
ii) Price/Earnings to Growth Ratio (PEG)
This valuation metric takes into account three variables –
- Price of the concerned stock
- Earnings per share or EPS
- The growth rate of the company.
It is calculated by using this formula:
PEG Ratio = P/E Ratio
growth rate in the EPS.
When you compare stocks using this metric, you are basically comparing how much you are paying for the growth in each stock. For instance, if you have stock with PEG of 1, it means that there the stock’s current market value is perfectly co-related to the earning growth rate. However, if you have a stock with higher PEG (let us say 2), it indicates that you need to pay twice as much for a similar growth trajectory. In simple words, the second stock is over-valued.
iii) Price /Sales Value
This valuation methodology helps to interpret the stock value in comparison to the sales or revenue produced by the company. Stocks with a lesser P/S score are interpreted as cheaper investment options as compared to stocks with a higher P/S value. One major limitation of this methodology does not take into account other critical factors such as costs or profitability. Hence it is advisable to look at this value not solely but in combination with other ratios.
It is calculated as:
Price/Sales Value = Price per share divided byTotal sale revenue.
Price / Book Value
The book value of the stock (the difference between the company’s assets and liabilities) is considered a comparatively stable parameter. Hence, using that for a stock’s valuation is a good idea. The Price / Book Value metric looks at the market value of the stock in relation to its net-worth. It is also known as the price-equity ratio. A stock with low P/B Value is often considered as an under-valued stock.
It is calculated as:
Price/Book Value = Price per share divided by book value per share.
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Warren Buffett once said – Price is what you pay, value is what you get! Hence, it is important to carefully look at the valuation to make a smart and profitable investing decision.