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Fundamental Analysis: Market Valuation – Basics

Updated: Dec 27, 2020

In your equity investment journey, a common term that you would've come across is Market Valuation. “This stock is trading at low valuation”, “The market is over-valued” are some frequent commentary that you would often read in financial newsletters. So, what exactly does it mean and how important is it for your equity investments?

This topic will be covered in 3 parts. The 1st part will set the context by explaining the various valuation ratios. Part 2, on how to interpret these ratios and Part 3 applies it on the current market. So let's get started!

Market Value of an equity asset is the money worthy-ness of the asset that the investors are willing to pay for. When a stock is traded in the exchange, the price quoted is the premium (in most cases) that a buyer is willing to pay after considering the business prospects of the company. This premium doesn’t remain constant, rather it fluctuates based on the expected future growth of the company. Hence, a stock’s traded price is the current value of each share based on its base value + the premium that an investor is willing to pay to own it. There is a subtle difference between the market value under discussion and "Market Capitalization".

Market Capitalization is,

(The total number of shares) * (Price quoted by each share in the exchange)

Market Cap is therefore the total value of the company at any given day. This does not give an indication of how the company is valued in terms of its performance. Market valuation solves this by acting as a metric for the premium that each share commands. I hope that, now you would have understood what market valuation means in the rough sense but why it is important? It helps you understand how the market “values” the company’s fortunes. A stock would command a high valuation when investors are very optimistic about its growth story or value it low, if they are not convinced by the company’s expected future prospects. Given this definition, to put this in to practice, we need to quantify the term "Market Valuation".

Market valuation is expressed as ratios which weigh the share price in terms of company’s assets or earnings. You would have frequently read about ratios such as P/E (Price to Earnings Ratio), P/B (Price to Book Value Ratio), EPS (Earnings Per Share) etc. Let's understand what these mean. Price to Book Value (P/B Ratio)

  • Book value is the actual net asset value of a company in accounting terms. It carries no influence of how the investors value it in the secondary market. Hence this is an unadulterated current value of the company based on its balance sheet and is derived as (Net Assets) – (Net Liabilities) converted to a value per share.

  • Price refers to the price traded in the market per share, which includes the premium quoted by investors for the stock.

  • The P/B ratio thus evaluates the price in terms of the base value of the company. This gives an idea of how many times (or multiples) of the true value, an investor is willing to pay.

  • For example, if a stock has a Book value per share (BVS) as 10 and if the Stock Price is 20, then the P/B multiple is 2. In words, this means the investors are willing to pay twice the actual value of the share to take part in it’s business journey. Meaning, the investor expects the company’s asset to grow more and the liabilities reduce in future beyond what they are paying today to reap a profit when the company delivers in future. In short, the company is said to be valued high. Likewise, in a rare case when this ratio becomes < 1, it means the investors do not expect the company to grow, rather, they expect it to shrink, i.e., valued low.

Earnings Per Share (EPS)

  • Earnings per share is a straightforward metric. As the name states, it is the annual earnings of the company divided by the total number of shares. This ratio again is similar to the concept of Book Value, where it is derived from the balance sheet and is the true value of the company expressed in terms of its profits.

  • Like BVS, EPS also does not give any insight to how the market values the company independently. That brings us to the next valuation ratio/multiple called the Price to Earnings Ratio (P/E) which uses EPS.

Price to Earnings (P/E Ratio)

  • This is probably the most widely used and debated valuation multiple used by fundamental analysts to value a company. As another multiple that evaluates the premium contained in share price of the company, this expresses premium in terms of the company’s earnings.

  • P/E is Stock Price divided by EPS, i.e., how many times (multiples) of the earnings that the investor is willing to pay to own a share.

  • For example, if a stock has a EPS of 50 and if the Stock Price is 525, then the P/E multiple is 10.5. In words, this means the investors are willing to pay more than 10 times what the company earns currently. Meaning, the investor expects the company’s future earnings to grow more than what they are paying for the share. In short, the company is said to be valued high and commanding a premium. Likewise, in a rare case when this ratio becomes < 1, it means the investors expect the company’s profits to shrink, i.e., valued poorly. A negative P/E indicates that the company is loss making.

P/E to Earnings Growth (PEG Ratio)

  • PEG ratio is an extension of P/E ratio which is used to get a closer estimate of the stock’s valuation.

  • In this multiple, the expected future growth of the company’s earnings is factored in.

  • For example, the P/E ratio itself is divided by the EPS growth expectation for the next 5 years. This gives a ratio of the stock valuation expressed in terms how earnings growth prospects. This provides more efficiency in determining the valuation in terms of future growth itself instead of the current earnings using in a P/E ratio. A PEG value of 1 indicates that the stock is fairly valued. A value > 1 indicates it is highly valued (commanding a premium for future growth) and < 1 indicates it is valued less.

Debt to Equity (D/E Ratio)

  • Debt to Equity is totally a different valuation metric which doesn’t involve the stock price for the ratio.

  • This ratio values a company based on leverage it has taken to run it’s business. Unlike price based ratios which are more dynamic on a day to day basis, D/E ratio is constant between each quarterly/annual earnings declaration.

  • D/E is fully derived out of the balance sheet and hence it’s a static valuation metric.

  • Also, it’s a valuation of the risk carried by the company unlike P/E ratio which is valued based on the price (premium). Evaluating risk is a very effective way to analyze a company because, the debts (liabilities) can hamper the projected growth of the company if not managed well.

These valuation ratios should serve well as an effective tool to understand more about the company that you want to invest in and take an informed decision by evaluating if the price you pay is justified.

In the next article, we would focus on how to interpret and use these valuation ratios while analyzing a stock. Though the bookish view of these ratios seems straight forward, the application would be bit more different in approach. I am sure that the next article would add more value to your DIY investment journey, that is often not discussed in the regular articles you would find in the internet. Don't miss it!

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