Summary
Equity valuation helps investors to understand whether a stock is undervalued, overvalued, or fairly valued.
It also includes various methods of determining the valuation of equity.Valuation of equity helps traders and investors to make decisions regarding buying, selling, and risk management.
What is the valuation of Equity?
Valuation of equity refers to the process of determining the fair value of a company’s stock that helps investors to measure whether the stock is undervalued or overvalued. It estimates the true value of a stock. It helps determine whether a share is trading above, below, or close to its fair value in the stock market. Estimating the valuation of equity involves evaluating a company’s financial fundamentals, such as its assets, liabilities, profitability, industry standing, and growth potential, to determine the fair value of its shares.
Investors usually interpret the equity valuation as mentioned below.
- When the market price is lower than the Intrinsic value, it is known as undervalued.
- When the market price exceeds its intrinsic value, it is known as overvalued.
- When the market value is close to the intrinsic value, it is considered fairly valued.
Rather than relying solely on market trends and investor sentiment, equity valuation helps investors assess key financial factors to make well-informed investment decisions.
Key Methods of Equity Valuation Explained Simply
The key methods used for the valuation of equity are mentioned below.
- Absolute valuation (Discounted cash flow): The absolute valuation is the process of determining the stock’s intrinsic value by estimating the future cash flow of the company. The widely used method is called discounted cash-flow (DCF). It is based on the idea that money available in the present has a higher value than future cash flows, as it can be invested and grow over time. Therefore, the estimated future cash flows are discounted back to their present value to determine the company’s intrinsic value and estimate its fair value today.
- Relative valuation (Comparable company analysis): The relative valuation is the process of estimating a company’s value by comparing multiple companies within the same industry. This displays the company’s position in the market. Relative valuation does not estimate the company’s intrinsic value directly, but it estimates the value of different companies in the market. Investors use various valuation multiples, including the P/E ratio, P/B ratio, and EV/EBITDA ratio, to assess a company’s valuation relative to its peers.
- Asset-based valuation (Balance sheet): Asset-based valuation is a method of determining a company’s value by calculating the difference between its total assets and total liabilities, thereby estimating its net asset value. It indicates the actual worth of a company if it chooses to wind up or liquidate itself. The asset-based valuation simply subtracts the liabilities from the assets of the company.
Many investors prefer to use a combination of valuation methods rather than relying solely on a single approach, as it provides a more comprehensive assessment of a company’s true worth.
Important Metrics used in Equity Valuation
To analyse a company’s valuation, investors use several metrics. The various metrics used in equity valuation are mentioned below.
- Price-to-earnings ratio: This indicates the price of a company’s share compared to the earnings gained per share.
- Price-to-book ratio: This indicates the price of a company’s share relative to the book value of the company.
- Price to free cash flow ratio: This indicates the market price of a share compared to the cash available after the cash expenditures.
- EV / EBITDA: It indicates the comparison between the total enterprise value, including debt, and the gross earnings before deducting interest, tax, depreciation, and amortisation of a company.
- PEG ratio: This indicates the comparison between the price-to-earnings ratio of a company and its expected earnings growth rate.
- Return to Equity: This represents the return earned on each unit of a share through efficient management.
- Dividend yield: This indicates the dividends paid by a company to its shareholders compared to the stock price.
Real-World Example: How Investors Value a Stock
Let’s understand the valuation of stock with the help of examples.
Scenario 1: Using Relative valuation
An investor, Mr H, wanted to analyse the valuation of different companies. He shortlisted three companies, ABC, XYZ, and PQR. The share price of company ABC is ₹250, and the earnings per share are ₹25. The company XYZ has shares priced at ₹300, and its earnings per share are ₹25. And the share price of company PQR is ₹400 with earnings per share of ₹25.
Now the P/E ratio of company ABC = 250 / 25 = 10x,
the P/E ratio of company XYZ = 300 / 25 = 12x,
And the P/E ratio of company PQR = 400 / 25 = 16x
Therefore the average P/E ratio is = (10 + 12 + 16) / 3 = 12.67x
After comparing the company’s valuation, Mr H realised that company ABC is undervalued because its P/E ratio is less than average. Company PQR is overvalued because its P/E ratio is more than average. And company XYZ is fairly valued because its P/E ratio is very close to the average.
Scenario 2: Using absolute valuation
Miss P wants to estimate the valuation of company ABC using the discounted cash flow method. The current free cash flow of company ABC is ₹4,00,000, and the company has 40,000 shares outstanding.
After analysing the company’s business, she expects its free cash flow to grow by ₹2,00,000 each year. Therefore, the estimated free cash flows for the next five years are ₹6,00,000, ₹8,00,000, ₹10,00,000, ₹12,00,000 and ₹14,00,000, respectively.
However, in a discounted cash flow model, future cash flows are not simply added together. They are discounted to their present value because money expected in the future is worth less than money available today.
Assume Miss P uses a discount rate of 10%.
| Year | Estimated free cash flow | Present value at 10% |
| Year 1 | ₹6,00,000 | ₹5,45,455 |
| Year 2 | ₹8,00,000 | ₹6,61,157 |
| Year 3 | ₹10,00,000 | ₹7,51,315 |
| Year 4 | ₹12,00,000 | ₹8,19,616 |
| Year 5 | ₹14,00,000 | ₹8,69,291 |
The total present value of the estimated free cash flows is around ₹36,46,834.
Therefore, the estimated value per share is:
₹36,46,834 / 40,000 shares = ₹91.17 per share
If the current market price of the share is ₹100, the stock may appear slightly overvalued based on this simplified DCF calculation.
However, this is only a basic example. In real valuation, investors may also include terminal value, debt, cash balance, business risks and future growth assumptions before deciding whether a stock is undervalued or overvalued.
How do Traders and Investors Use Equity Valuation in Practice?
Traders and investors use equity valuation to estimate the intrinsic value of a company and make decisions for buying and selling, strategies, and risk management. Although both traders and investors share the same goal, they apply the equity valuation based on the company’s risk profile and tenure.
- Long-term value investor: Long-term investors rely on equity valuation to identify stocks which are undervalued today but have the potential to generate substantial returns over time. They look for opportunities to buy shares at a discount.
- Active trader and swing trader: Valuation is used by traders to identify the stock’s intrinsic value compared to its market value for short-term trades. They check whether the stock price is influenced solely by market variation. Although valuation is not the only important factor for short-term trades, it provides traders with a useful insight into identifying trading opportunities.
- Growth investor: Growth investors especially look for companies that have the potential to expand in the future. Valuation helps growth investors to understand if the current market price justifies the growth potential of the company, for which they may even pay a premium.
- Institutional investors and fund managers: Valuation is used by institutional investors and fund managers to identify opportunities across different companies and industries to improve the investment portfolio. They use valuation to identify stocks that align with their investment objective.
Common Mistakes in Equity Valuation and How to Avoid Them
There are various mistakes made by investors and traders while using equity valuation. Some of them are mentioned below, along with how to avoid them.
| Common mistakes | How to avoid |
| Over estimating future growth of a company. Many analysts project the company’s growth higher than the possible growth to attract investors | Investors can use terminal growth rate to assume the potential growth of a company based on competition, economic conditions, and industry trends before making an investment |
| Investors using inappropriate companies or industries for comparison | Compare companies or industries that have similar capital structure, growth rate, industry and market position |
| Many investors confuse a stock’s market price with its intrinsic value | Analyse the company’s fundamentals to determine its intrinsic value instead of only relying on the market price |
| Companies can be profitable and still hold significant debt and hidden liabilities hampering the future growth | Analyse the financial statements and identify any contingent liabilities that may affect the overall cashflow of the company |
Start Practicing Equity Valuation (Actionable Learning)
Practicing equity valuation before investing will provide insight into the terms and process of estimating the intrinsic value of a company and how it can be utilised to make investment decisions.
- Pick a target company: Choose a company that is familiar. Selecting an established and well-known company may be easier to understand and analyse because of the availability of information.
- Understand the financial statements: Understand the accounting statements of the company. Analyse the income statement, balance sheet, and cash flow statement to understand the financial performance of the company.
- Build a discounted cash flow model: Create a discounted cash flow model to estimate the future potential growth and calculate the present value of the company based on it. Calculate the weighted average cost of capital and the cost of equity of the company. Assuming the future growth rate will provide a view on the company’s earning potential and intrinsic value.
- Perform comparable company analysis: Compare the selected company with companies that belong to the same industry and have similar market position and capital structure. Calculate the metrics such as P/E ratio, P/B ratio, and return on equity to understand the valuation relative to its competitors.
- Note the outcomes: Note down the outcomes and understandings. Compare the estimated intrinsic value of the company with its market price and notice whether the company is undervalued, overvalued, or fairly priced.
The practice of valuation will help to understand assumptions and their results, learn from mistakes, and bring overall improvement in analytical skills.
Final Thoughts
Valuation of equity is the process of estimating the intrinsic or fair value of a company to understand if a company’s actual worth is undervalued, overvalued, or fairly valued. Investors analyse various factors, such as financial statements and potential growth rate, to understand the actual value of the company and make informed decisions based on their financial objectives and risk tolerance. The valuation of equity helps investors to look into the opportunities and risks associated with a company.
However, investors should avoid overestimating the growth rate, performing inappropriate comparisons, and ignoring hidden liabilities and debt of a company for a more accurate fair value of the company. By practicing analysis of financial statements, performing comparisons, and reviewing outcomes without using real money, investors can also improve their analytical skills and make disciplined investment decisions. Therefore, equity valuation helps investors and traders to estimate the actual value and compare it with the current price of a company, and find opportunities with a suitable financial objective.
FAQs
Equity valuation is the estimation of the intrinsic or fair value of a company to determine whether the company is undervalued, overvalued or fairly priced.
The relative valuation method is considered better for beginners because it allows quick access to a stock’s valuation by simply calculating a P/E ratio or P/B ratio.
Yes, equity valuation is useful for short-term trading to understand the price of the underlying fundamentals. It can provide context, but short-term traders usually rely more on price action, liquidity, news flow and technical indicators.
The market value is the current price of a company’s stock in the market. On the other hand, intrinsic value is the estimated value of a company based on financial analysis and growth potential.
Yes, you can practice equity valuation without dealing with real money and gain experience by analysing big, well-known companies and calculating their valuation ratios.
You can evaluate a stock’s valuation once every quarter when a company discloses its financial performance.
