Stock valuation: What does it mean and what are the key matrices to determine it?

Valuation has been the buzzword lately. After the outperformance of the Indian market in 2022, analysts and brokerage firms have been pointing out that the market is at a rich valuation.

In simple terms, the market value of a company is the market capitalisation of a company; it is calculated by multiplying the number of its outstanding shares by its current share price. 

For example, if a company has 1,000 outstanding shares and the current market price of its one share is ₹10, the market value of the company is ₹10,000.

It is clear that determining the market value of an exchange-traded company or instrument is easy.

But what does it show?

The market value of a stock, ETF, index, etc. shows investors' perception towards that instrument. But how do we know whether an instrument justifies its current market value or not?

This is when different matrices to determine the valuation of a stock come into the picture.

Let's make it more clear.

What does stock valuation mean?

The valuation of a stock means its worth of it in the market. There are different methods to gauge the valuation of a stock. Some investors also consider the growth prospects of a company to determine the value of a stock.

Analysts point out that there are several equity valuation models, such as the book value approach, the asset-based approach, the discounted cash flow (DCF), the comparables approach and the precedent transaction approach.

Let's understand them separately.

The book value approach: This is one of the most simple methods of valuing a company which involves a company's balance sheet.

According to Harvard Business School, to calculate book value, start by subtracting the company’s liabilities from its assets to determine owners’ equity. Then exclude any intangible assets. The figure you’re left with represents the value of any tangible assets the company owns.

The asset-based approach: This approach determines a company's value on the fair market value of net assets owned by the company.

The discounted cash flow: This approach is one of the most used techniques to determine the valuation of a stock. 

In this process, the value of a company is determined by considering the money, or cash flows, it may generate in the future.

As per Harvard Business School, discounted cash flow analysis calculates the present value of future cash flows based on the discount rate and time period of analysis.

The precedent transaction approach: According to CFI, the precedent transaction approach is a method of company valuation where past M&A (mergers and acquisitions) transactions are used to value a comparable business today.

The comparables approach: Under this, a company's valuation is calculated by comparing it to other companies in the same group or class. 

Probably the most used equity valuation method, investors use different matrices, such as enterprise value-to-EBITDA, EPS (earnings per share), PE or P/E (price-to-earnings ratio), D/E (debt-to-equity), RoE (return on equity) and P/B (price-to-book ratio), to determine the value of stock under comparables approach.

Key matrices

Enterprise value-to-EBITDA: As per CFI, EV/EBITDA is a ratio that compares a company’s enterprise value (EV) to its earnings before interest, taxes, depreciation and amortization (EBITDA). 

The EV/EBITDA ratio is commonly used as a valuation metric to compare the relative value of different businesses.

EV is equal to its equity value (or market capitalisation) plus its debt (or financial commitments) less any cash (debt less cash is referred to as net debt).

EBITDA is a profitability metric and is calculated in a straightforward manner, using data from the income statement and balance sheet of a corporation.

EPS: EPS measures the profitability of a firm on a per-share basis but does not account for convertible options. It is calculated by this formula: EPS = (Net income – Preferred dividend) / Outstanding shares.

PE: PE Ratio is the ratio between a company's stock price and its earnings per share. It is used to determine the market value of a firm.

PE= (Current Market Price of a Share / Earnings per Share). A high PE indicates a stock price is high compared to its earnings and vice versa.

PB: PB ratio generally indicates whether the stock is worth how much the investor is paying and how much will the investor get if it goes bankrupt. Usually, if the PB ratio of a stock is lower, then it indicates that the stock is undervalued and vice versa.

DE: Debt-to-equity ratio indicates the total debt and financial liabilities against total shareholders’ equity.

Debt to equity ratio: (short-term debt + long-term debt + fixed payment obligations) / Shareholders’ Equity.

RoE: Return on equity is calculated by dividing the net income of a firm by its shareholder's equity.

Return on Equity (ROE): Net income / Total shareholder's Equity of the Company.