Stock valuation is a way to figure out how much a stock is actually worth, without considering its current market price. This means that the real value of a stock may be different from what it is currently being traded for. Understanding stock valuation is becoming more and more important for investors to make informed decisions when buying or selling stocks.
Before we get into technicalities, let’s understand the basics.
Why is one stock a good buy at ₹180 while another stock from the same industry is not so good at ₹100 a piece? Why are analysts recommending a ₹7,000 a piece stock when plenty of ‘cheap’ stocks with under ₹10 price tags are available in the market? If you have these questions in mind, you are not alone.
As American stock investor Philip Arthur Fisher once said: The stock market is filled with individuals who know the price of everything and maybe the value of nothing.
Understanding whether a stock is ‘cheap’ does not depend on share price but on the intrinsic or real value of the company. This is how you value a stock. The process to evaluate the intrinsic value of a stock is called stock valuation.
Content:
- Meaning of valuation of shares
- Need for valuation of shares
- Methods of valuation of shares
- Factors affecting valuation of shares
- Quick Summary
- FAQ
Meaning of Valuation of Shares
Stock valuation helps determine the true value of a stock, independent of its current market price. This is important for investors to identify if a stock is overvalued or undervalued. It also aids in predicting future price movements.
Once an investor knows the intrinsic value of a stock, he/she can find out whether the stock is overvalued or undervalued from its current market price. It also helps in predicting the future price and possible movement of the stock.
Using certain set formulas and methods, an investor can find out the value of the stock or share. All the methods work on some set parameters that help you determine the value of the stock. Some of the parameters are fundamentals of the company, reports on the stock performance, sectoral trends, etc.
Need for valuation of shares
Stock valuation is required:
- To determine the intrinsic value of the stock
- To make an informed decision about the stock sale or purchase
- To know the depth of current market price of a stock
- To prepare for a knee-jerk reaction to the market
When it comes to investment, it is crucial for an investor to know the actual value of the stock and do some value investing. Click here to learn what is value investing. Read along to learn about stock valuation methods.
Methods of valuation of shares
Stock valuation methods can be categorized into two main types:
- Yield method of valuation of shares
- Net assets method of valuation of shares
1. Yield Method of Valuation of Shares
This is also called the market-based valuation method. In this method you take into account the expected effective yield of numerous comparable stocks and accordingly figure out the valuation of the stock you are most interested in.
One can do this valuation by two ways – earning yield and dividend yield. In the earning yield, the stock is valued on the basis of expected earnings and the normal rate of return and the dividend yield is based on the expected dividend and the normal rate of return.
a. Earning Yield Variant
Value of share = (expected rate of earning / normal rate of earning) * paid up value of a share
Where, expected rate of earning = (Profit available for equity shareholder/paid up equity share capital)* 100
For example, if a company’s profit after tax is ₹10,000, normal rate of earning 5 per cent, paid-up value of a share ₹10 and total number of shares 10,000, then this is how you will calculate the valuation of a share –
Paid-up equity share capital = Paid-up value of a share * number of shares
= ₹10 * 10,000
= ₹1,00,000
expected rate of earning = (10,000/1,00,000)*100
= 10%
Value of a share = (10/5)*Rs 10
= ₹20
b. Dividend Yield Variant
It is exactly similar to the earning yield variant except that expected rate of dividend is used.
Value of share = (expected rate of dividend / normal rate of dividend) * paid up value of a share
Where, expected rate of dividend = (Profit available for equity shareholder/paid up equity share capital)* 100
Taking forward the above example, expected rate of dividend will come out to be the same at 10 per cent. If the normal rate of dividend is 2 percent, then this is how the valuation of a share will be calculated:
Value of a share = (10/2)*10
= ₹50
2. Net Assets Method of Valuation of Shares
This valuation method takes into account the net assets value of the company. You need to first figure out the total assets and liabilities of the company. You arrive at net assets after subtracting the liabilities from the assets. The non-trading assets such as goodwill of the company, etc should also be included in total assets. Once you have the net asset value, you divide it by the number of equity shares to determine the intrinsic value of the share.
Value of the share = net assets available to equity shareholders / number of equity shares
For example, if a company’s total assets come out to be ₹10 lakh and liabilities ₹2 lakh, then the net assets will be ₹8 lakh. Now if the number of equity shares are 10,000, then this is how you will calculate the valuation of a shares:
Value of share = 8,00,000/10000
= ₹80
Another important factor to know about while the valuation of shares is the PE Ratio. Read about what is PE Ratio here.
Factors Affecting Valuation of Shares
- Fundamentals of the company
- Unforeseen changes in the economy and the stock market
- The net-worth of the company
- How old and efficient is the plant and machinery of the company.
- Dividend paid by the company over the years
- Future growth prospects
- Debt level of the company
- The management and board of directors of the company
To learn about the dividend payments of the company, read our blog on corporate actions.
Quick Summary
- Stock valuation is a way to determine the intrinsic value of a stock. The intrinsic value or the theoretical value of the stock is not linked or attached to its current market price. Therefore, stock valuation holds much more importance.
- Stock valuation is required to determine the intrinsic value of the stock and to make an informed decision about the stock sale or purchase. It is also important to know the depth of the current market price of the stock and prepare yourselves for a knee-jerk reaction to the market
- Stock valuation methods can be categorized into two main types:
- Yield method of valuation of shares
- Net assets method of valuation of shares
Frequently Asked Questions
What is the meaning of the valuation of shares?
Valuation of shares means calculating how much a company’s shares are worth by looking at its financial performance, market trends, and other relevant information. It helps investors and analysts to assess the potential value and risks associated with the company’s shares before making any investment decisions.
How is valuation calculated?
The valuation of shares is calculated based on the company’s earnings, assets, growth potential, and other factors. Common methods include the P/E ratio and DCF analysis. Market dynamics and investor sentiment can also influence valuation.
What is the importance of the valuation of shares?
Valuation of shares is important because it helps investors and companies understand how much a company’s stock is worth. This information is used to make important financial decisions, such as whether to invest in a company or to merge with another company.
What is the difference between share price and valuation?
Share price is the price of a single share of a company’s stock, while valuation is an estimate of the entire company’s worth.
