Section | Title | Description |
---|---|---|
10.1 | Valuation Overview | Basics of valuation, purpose, and how it helps in investment decision-making. |
10.2 | Valuation vs Price | Difference between intrinsic value and market price; why they may differ. |
10.3 | Relative Valuation | Comparing companies using valuation multiples like P/E, P/B, EV/EBITDA, etc. |
10.4 | Absolute Valuation | Discounted Cash Flow (DCF) and Dividend Discount Models (DDM) based on future cash flows. |
10.5 | Discounted Cash Flow (DCF) Model | Core principles of DCF, how it works, and key inputs: cash flows, discount rate, terminal value. |
10.6 | Dividend Discount Model (DDM) | Model based on the present value of expected future dividends for valuing dividend-paying companies. |
10.7 | Price Multiples | Key valuation multiples and when to use them: P/E, P/B, EV/EBITDA, EV/Sales, PEG ratio. |
10.8 | Valuation in Practice | How analysts combine different methods for practical valuation and risk-adjusted decision making. |
The terms price and value are often used interchangeably in markets, but they represent two fundamentally different concepts. Understanding this difference is essential for any investor or research analyst.
Price is the amount at which an asset is currently bought or sold in the market. It is determined by the forces of demand and supply and can fluctuate frequently due to market sentiment.
Value, specifically intrinsic value, is the actual worth of an asset based on fundamentals—such as cash flows, earnings potential, business quality, and risk factors. Value tends to be more stable over time and is not easily influenced by short-term market noise.
Aspect | Price | Value |
---|---|---|
Definition | Current trading amount in the market | Estimated worth based on business fundamentals |
Basis | Demand and supply, news, market sentiment | Future cash flows, earnings, assets, risk profile |
Volatility | Highly volatile and short-term | Relatively stable and long-term oriented |
Visibility | Visible on market screens and tickers | Requires detailed analysis and estimation |
Example | Stock of XYZ is trading at ₹120 | Its intrinsic value may be ₹150 |
✅ Example: A stock may trade at ₹100 in the market (price), while its actual worth based on projected earnings and future cash flows (value) is ₹150. This difference creates an investment opportunity.
⚠️ Note: Market price may be above or below value due to investor emotions, speculation, or short-term events. Analysts must focus on value to make rational investment decisions.
Great investors like Warren Buffett emphasize the importance of value investing—buying stocks at a price lower than their intrinsic value and holding them until price and value converge. Understanding this gap is key to successful long-term investing.
Valuation is the process of estimating the intrinsic value of an asset—such as a stock, company, or business segment—based on its fundamentals. It plays a critical role in making informed investment decisions, especially when market prices do not always reflect true worth.
Valuation provides a rational basis for buying, holding, or selling a stock. It helps determine whether a stock is:
Investors, fund managers, and analysts use valuation to assess risk, compare investment options, and allocate capital efficiently. It also aids in long-term planning, mergers, acquisitions, and fundraising strategies.
Use Case | Purpose of Valuation |
---|---|
Investment Decision | Helps determine if a stock is worth buying or selling |
Portfolio Management | Assists in adjusting holdings based on valuation gaps |
IPOs / Fundraising | Supports price discovery and negotiation with investors |
M&A Deals | Helps assess target company value for acquisition offers |
Corporate Restructuring | Used in demergers, buybacks, and share swaps |
✅ Example: An investor finds a company trading at ₹100 with a calculated intrinsic value of ₹160. This valuation insight supports a strong buy recommendation with a potential 60% upside.
⚠️ Note: Valuation is based on assumptions and projections. If input estimates like cash flows or discount rates are flawed, the output (intrinsic value) can mislead. Analysts must be cautious and conservative.
Valuation is the foundation of disciplined investing. Rather than chasing price trends, it encourages evidence-based decision-making. Whether comparing stocks, negotiating deals, or managing portfolios—valuation provides direction and clarity.
The two primary sources of value in any business are: (1) Earnings Power – the ability to generate profits, and (2) Asset Base – the tangible and intangible resources owned by the business.
Understanding what drives a company’s value—its consistent earnings or strong asset base—helps in choosing the right valuation model. Some businesses are earnings-driven, while others are asset-heavy or asset-dependent.
Earnings represent the company’s profitability and cash flow generation capabilities. Businesses with steady revenue, high margins, and consistent growth are typically valued using methods like:
✅ Example: Infosys is valued primarily on its earnings potential due to high profitability and stable cash flows. Investors focus on P/E and DCF-based valuations for such companies.
Some companies derive value from the assets they own—such as land, machinery, patents, brands, or investments. In such cases, valuation may be based on:
✅ Example: Real estate companies like DLF are often valued based on the market value of their land bank, even if their earnings fluctuate over time.
⚠️ Note: Analysts must evaluate whether the business generates value through operational performance or relies on appreciation in asset values. The chosen valuation approach must reflect this distinction.
Some companies may derive value from both earnings and assets. For instance, banks and insurance companies are analyzed using a combination of earnings power and asset/liability strength. Valuation must be customized to business characteristics.
Relative Valuation is the process of valuing a company by comparing it to similar companies, typically within the same industry or sector. This approach relies on market-based metrics, and is commonly used due to its simplicity, especially when precise intrinsic valuation models are difficult to apply.
Relative valuation uses valuation multiples—such as the Price-to-Earnings (P/E) ratio or Enterprise Value-to-EBITDA (EV/EBITDA)—to compare the company’s market value to that of similar companies. The idea is that companies in the same industry or with similar financials should be valued in similar ways.
The most commonly used multiples in relative valuation are:
The Price-to-Earnings (P/E) ratio compares the market price per share to its earnings per share, and is widely used for companies that are profitable. A high P/E ratio may indicate that the company is overvalued or has high growth expectations, while a low P/E ratio may suggest undervaluation.
The EV/EBITDA multiple is particularly useful for comparing companies with different capital structures, as it compares enterprise value to earnings before interest, taxes, depreciation, and amortization (EBITDA).
Ratio | Usage | Interpretation |
---|---|---|
P/E Ratio | Compare valuation across companies | High P/E = High growth expectation, Low P/E = Possible undervaluation |
P/B Ratio | Measure market price relative to book value | Above 1 indicates market values company higher than its book value |
EV/EBITDA | Compare enterprise value to operational profitability | Lower ratio = More attractive; often used for capital-intensive industries |
P/S Ratio | Compare market capitalization to sales | Useful for companies with negative earnings or startups |
✅ Example: If the P/E ratio of Company A is 15, and Company B’s P/E is 20, then Company A might be considered undervalued relative to Company B, assuming both are in the same industry and have similar growth prospects.
⚠️ Note: Relative valuation does not account for the differences in risk, future growth, or market conditions. Hence, it is important to apply these ratios only when comparing companies with similar characteristics.
Relative valuation is particularly effective for valuing companies in mature industries where comparison is easier. However, it should be used with caution when comparing companies in different sectors, growth stages, or financial conditions.
The Discounted Cash Flow (DCF) Model is a fundamental valuation approach used to estimate the value of a business based on its projected future cash flows. It is widely regarded as one of the most reliable and accurate methods for valuing companies with predictable and stable cash flows.
The DCF model values a company based on the present value of its expected future free cash flows (FCF). These cash flows are discounted at an appropriate discount rate to account for the time value of money, and the sum of these discounted cash flows provides the company’s intrinsic value.
✅ Formula:
DCF Value = Σ (FCF in Year t / (1 + r)^t)
Where
FCF = Free Cash Flow,
r = Discount Rate (WACC),
t = Year (time period)
Component | Explanation |
---|---|
Free Cash Flow (FCF) | Cash available to shareholders after operating expenses and capital expenditures |
Discount Rate (WACC) | Weighted average cost of debt and equity capital used to discount future cash flows |
Terminal Value | Value of the business after the forecast period, often calculated using perpetuity growth |
✅ Example: If a company is expected to generate ₹10 million in free cash flow next year, and the discount rate is 10%, the present value of that future cash flow would be ₹9.09 million. This process is repeated for all future years, and the terminal value is added for a complete valuation.
⚠️ Note: The accuracy of a DCF model depends heavily on the quality of the input assumptions—such as projected cash flows, growth rates, and discount rates. Small changes in assumptions can have a significant impact on the final valuation.
The DCF model is particularly useful for companies with stable, predictable cash flows, such as large-cap, mature companies. However, for startups or high-growth companies, projecting future cash flows with certainty is difficult, making other valuation methods (like relative valuation) more appropriate.
Relative Valuation is the process of valuing a company by comparing it to similar companies, typically within the same industry or sector. This approach relies on market-based metrics, and is commonly used due to its simplicity, especially when precise intrinsic valuation models are difficult to apply.
Relative valuation uses valuation multiples—such as the Price-to-Earnings (P/E) ratio or Enterprise Value-to-EBITDA (EV/EBITDA)—to compare the company’s market value to that of similar companies. The idea is that companies in the same industry or with similar financials should be valued in similar ways.
Earnings-based valuation matrices are essential tools for investors to determine the value of a company based on its earnings performance. These metrics offer insights into how the market prices a company’s earnings and help investors compare companies within the same industry or sector.
The Dividend Yield ratio compares the annual dividend payment to the current market price of a company’s shares. It provides investors with an idea of the income they can expect from their investment relative to its market price. This ratio is particularly important for income-focused investors who prioritize dividends over capital appreciation.
✅ Formula:
Dividend Yield = Dividend per Share / Price per Share
A high dividend yield may indicate that the company is offering an attractive income stream relative to its stock price. However, an excessively high dividend yield could signal that the company is facing financial difficulties or that the stock price is undervalued.
✅ Example: If a company pays ₹10 per share as annual dividend and the stock price is ₹100, the dividend yield would be 10% (₹10 / ₹100). This means an investor would earn ₹10 for every ₹100 invested in the stock.
The Earnings Yield is the inverse of the Price-to-Earnings (P/E) ratio, providing insight into the percentage of earnings relative to the stock price. It’s useful for comparing the earnings potential of different companies in the same industry or sector.
✅ Formula:
Earnings Yield = Earnings per Share / Price per Share
A higher earnings yield suggests that a company is generating more profit relative to its stock price, which is favorable for value investors. A lower earnings yield indicates that the company might be overvalued or has low growth prospects.
✅ Example: If a company has ₹15 earnings per share (EPS) and its stock price is ₹100, the earnings yield would be 15% (₹15 / ₹100). This indicates that the company is generating ₹15 in earnings for every ₹100 invested in the stock.
The Price-to-Earnings Growth (PEG) Ratio adjusts the P/E ratio by a company’s earnings growth rate, making it more useful for comparing companies with different growth rates. The PEG ratio helps investors determine if a company is fairly valued, overvalued, or undervalued based on its growth expectations.
✅ Formula:
PEG Ratio = P/E Ratio / Earnings Growth Rate
A PEG ratio of 1 suggests that the stock is fairly valued in relation to its growth rate. A ratio greater than 1 may indicate that the stock is overvalued, while a ratio less than 1 may suggest the stock is undervalued.
✅ Example: If a company has a P/E ratio of 20 and an earnings growth rate of 5%, the PEG ratio would be 4 (20 / 5). This means the stock is trading at a premium based on its growth rate.
The Enterprise Value to EBIT(DA) Ratio compares a company’s enterprise value (EV) to its earnings before interest, taxes, depreciation, and amortization (EBITDA). This ratio is used to evaluate how much investors are willing to pay for a company’s earnings capacity, excluding the impact of capital structure and accounting practices.
✅ Formula:
EV/EBITDA = Enterprise Value / EBITDA
A lower EV/EBITDA ratio suggests that the company may be undervalued, while a higher ratio indicates that the company is priced at a premium compared to its earnings potential.
✅ Example: If a company has an enterprise value of ₹1,000 million and EBITDA of ₹100 million, the EV/EBITDA ratio would be 10 (₹1,000 million / ₹100 million). This suggests the company is valued at 10 times its earnings before interest, taxes, depreciation, and amortization.
The EV to Sales Ratio compares a company’s enterprise value to its total revenue (sales). This ratio is especially useful for evaluating companies with low or negative earnings, such as startups or companies in the early stages of growth.
✅ Formula:
EV/Sales = Enterprise Value / Revenue
A lower EV/Sales ratio suggests that the company is undervalued relative to its revenue. A higher ratio may indicate that the stock is overpriced relative to its sales.
✅ Example: If a company has an enterprise value of ₹500 million and annual sales of ₹250 million, the EV/Sales ratio is 2 (₹500 million / ₹250 million). This means investors are willing to pay 2 times the company’s annual sales for its entire enterprise value.
Assets-based valuation matrices help determine the value of a company based on its assets, both tangible and intangible. This method is most commonly used for companies that own significant physical or intellectual property assets, such as real estate, manufacturing, and natural resource companies.
Asset-based valuation is based on the premise that the value of a company is the sum of its individual assets, after deducting liabilities. This approach is especially useful for capital-intensive industries where tangible or intangible assets contribute significantly to the business’s value.
The Price to Book Value (P/B) Ratio compares a company’s market price to its book value per share. The book value represents the net value of a company’s assets after liabilities have been deducted. A P/B ratio of less than 1 indicates that the company is trading below its book value, which may signal undervaluation.
✅ Formula:
P/B Ratio = Price per Share / Book Value per Share
The P/B ratio is particularly important in asset-heavy industries, such as banks, insurance firms, and real estate companies, where the book value of assets is a significant indicator of the company’s worth.
✅ Example: A company’s stock is priced at ₹200 per share and its book value per share is ₹150. The P/B ratio would be 1.33 (₹200 / ₹150). This suggests that the market is willing to pay ₹1.33 for every ₹1 of net assets held by the company.
The Enterprise Value to Capital Employed Ratio compares the total enterprise value (EV) of a company to its capital employed, which includes both equity and debt. This ratio provides insight into how efficiently the company is using its capital to generate value.
✅ Formula:
EV/Capital Employed = Enterprise Value / Capital Employed
A high EV/Capital Employed ratio indicates that a company is generating more value from its capital. Conversely, a low ratio may suggest inefficiency or underperformance in utilizing capital resources.
✅ Example: If a company has an enterprise value of ₹1,000 million and capital employed of ₹500 million, the EV/Capital Employed ratio is 2 (₹1,000 million / ₹500 million). This indicates that for every ₹1 of capital employed, the company generates ₹2 in value.
The Net Asset Value (NAV) approach values a company by subtracting its total liabilities from its total assets. This method is particularly useful for asset-heavy industries, where the company’s value is primarily driven by its assets rather than its earnings.
✅ Formula:
NAV = Total Assets – Total Liabilities
NAV can be calculated on a per-share basis by dividing the net assets by the total number of shares outstanding. This gives investors an estimate of the company’s value if all assets were sold and liabilities paid off.
✅ Example: If a company has assets worth ₹1,500 million and liabilities totaling ₹900 million, its NAV would be ₹600 million (₹1,500 million – ₹900 million). If there are 100 million shares outstanding, the NAV per share would be ₹6 (₹600 million / 100 million shares).
In addition to the P/B ratio, EV/Capital Employed, and NAV, there are several other useful metrics to evaluate a company based on its assets. These metrics provide additional insight into a company’s efficiency, profitability, and the value of its tangible and intangible assets:
Relative Valuation is a method used by analysts and investors to compare a company’s value with that of similar companies, using financial metrics (ratios or multiples). It offers a quick and effective way to assess whether a company is overvalued or undervalued in the market. This method is primarily divided into **trading multiples** and **transaction multiples**, each serving distinct purposes in the valuation process.
Trading multiples are based on the current market value of a company, and they are primarily used for comparing a company’s value relative to its performance metrics. These ratios help investors gauge how much the market is willing to pay for a company’s earnings, sales, or assets at the current moment.
The most commonly used trading multiples include:
Transaction multiples are based on the actual prices paid in comparable past mergers and acquisitions (M&A) transactions. They are typically used in valuation for M&A activity and provide insight into what others have been willing to pay for similar companies in the same industry.
These multiples are typically considered more reliable than trading multiples because they reflect actual market transactions and are not subject to fluctuations in the stock market.