When it comes to investments, one of the core aspects is stock valuation. It deals with the proper evaluation of a company before investing capital into its shares. Even if you land a good company as an investor, but carry out an incorrect valuation of the stock, it can turn out to be a loss-making investment.
- There are two types of valuation of stocks – absolute valuation and relative valuation.
- Absolute valuation values the company based on its financials, present and future, in isolation without comparing it to another company or the broader industry.
- Relative valuation of stocks considers a few factors like industry average and the historical performance of stocks, and it compares the company’s financials with that of its competitors.
- Relative valuation of stocks is considered as an alternative to absolute valuation and is an effective and simple way to decide whether the stock is worth investing in or not.
Steps in relative valuation
- The first step in the relative valuation model is setting a benchmark. The comparison to be made needs to have a comparable basis – companies from the same industry with similar market capitalisation. For instance, you should compare a large cap stock in the real estate industry with other large cap companies in the real estate industry only.
- Let us assume that there are five companies in the real estate industry with an average Price-to-Earnings (P/E) ratio of 20. If we look at the P/E ratio of the company that you are looking to invest in and say it turns out to be 15, then it can be termed comparatively cheaper than the other stocks in the same industry.
- After a careful analysis using multiple financial ratios, we try to find the stock’s relative value. If, after using relative valuation multiples, we observe it to be comparatively cheaper, it is safe to assume the stock in the picture is undervalued.
Tools to perform a relative valuation of stocks
Out of multiple financial ratios available to conduct a relative valuation of stocks, below are the most common and preferred ones:
- Price-to-Earnings (P/E) ratio
The P/E ratio is the most popular method in the relative valuation model. It signifies the amount investors are willing to invest in procuring that stock in return for its earnings. A high P/E ratio signifies that the investors are paying more to buy the shares. The P/E ratio is calculated using this below given formula:
Price-to-Earnings ratio = (Price per share) / (Earnings per share)
- Price-to-Book Value (PBV) ratio
The book value generally regards the net asset value of a company. It can be worked out as total assets subtracting all the intangible assets (patents, goodwill) and liabilities. Further, it is computed by dividing the current price of the shares by the book value per share. The formula for computation is:
Price-to-Book ratio = (Price per share) / (Book value per share)
- Price-to-Sales (P/S) ratio
When the price of a company’s stock is measured against its annual sales value, we arrive at the P/S ratio. Like the P/E Ratio, the P/S ratio is another useful relative valuation indicator. The formula is:
Price-to-Sales ratio = (Price per share) / (Annual sales per share)
The above methods are helpful in understanding and computing the relative valuation of stocks. It is advisable that these ratios be utilised to their maximum potential to get a clearer picture of your stock market investments.