Key Valuation Methods

Regardless of whether the capital markets are bullish or bearish, the majority of investors typically struggle with deciding when to enter and leave a position in a particular stock in order to maximise their earnings. Investors typically want to know the stock's value before they buy, hold, or sell it. The stock's value could be either its existing or its future value. Every investor enjoys buying stock at a lower market price and selling it for more money than it is actually worth. The big question, though, is "How to evaluate a particular stock?" Despite the fact that there are numerous ways of valuation, they all require an evaluation of the firm or business as a whole.

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To ascertain the economic value of the promoter's interest in the business, a technique and a series of procedures called business valuation are applied. Financial professionals utilise a variety of methods and strategies for valuation to figure out what they are willing to pay or get to complete a business sale. These valuation tools are employed by experts for a variety of business and legal purposes, including resolving family disputes, mergers and acquisitions, and determining the selling price of a company.

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As shown in a number of recent capital market booms, including the IT boom, the real estate boom, the retail boom, etc., share values typically peak during the boom phase before collapsing once mood shifts, resulting in significant losses for the investors. If an investor understands how to value a stock, they can avoid such a dilemma. The following are a few of the most widely used valuation techniques:

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(1) Discounted Cash Flow Method (DCF): Stock market analysts frequently use this technique to value the companies they follow. The company's projected future cash flows for the following three to five years are taken into account and then further adjusted for time value of money. To determine the present value of anticipated future cash flows, these cash flows are discounted by the company's weighted average cost of capital. The investor can determine the stock's intrinsic value as of today by dividing the entire cash flows by the total number of shares that have ever been issued. It goes without saying that if a stock's market price is less than its intrinsic worth, it is undervalued, and vice versa.

Despite the difficulties, DCF is thought to be the most trustworthy approach for determining fair value after taking future organisational performance into account.

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(2) Price Earnings Ratio (P/E Ratio): This is one of the most often utilised techniques for valuing stocks by regular investors. It is determined by subtracting the market price from the earnings per share (EPS). A lower P/E ratio typically indicates that a company is cheap and has room to rise in value. Investors evaluate the P/E ratios of businesses in the same industry to determine whether a particular stock is undervalued or overvalued because every industry has a distinct trend in P/E ratios. It should be highlighted that the P/E ratio alone cannot be utilised to make decisions; instead, investors should consider the sustainability and quality of earnings before making a choice. They should also carefully examine the company's outstanding obligations because P/E does not account for them.

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(3) Enterprise Value to Operating Profits (EV/EBITDA): The enterprise value, or EV, is the total of the market capitalization and the outstanding long-term liabilities. Earnings Before Interest, Taxes, Depreciation, and Amortization is referred to as operating profit. A valuation multiple known as EV/EBITDA is frequently employed in conjunction with or in place of the P/E ratio. This ratio is frequently used for appraising cash-based enterprises. This multiple has the benefit of being independent of capital structure. This multiple can therefore be applied directly across enterprises.

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(4) Enterprise Value to Sales Ratio (EV/Sales): This ratio is determined by dividing Enterprise Value by the Company's annualised sales. The EV/Sales technique is typically used to value businesses with high turnover but low profitability or losses.

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(5) Sum of the Parts (optional) Valuation: In the case of diverse organisations, each of their businesses is valued individually using suitable valuation methodologies before the sum of all businesses is finally taken into consideration for stock valuation. For instance, Mahindra & Mahindra, ICICI Bank, Larsen & Toubro, etc.

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Since valuation is a highly individualised term, various people may view the same stock's value differently. The capital market moves arbitrarily and at its own pace in a highly dynamic environment where investors attempt to value equities based on a variety of factors such as liquidity, general sentiment, the state of the economy, changes in government policy, etc. In addition to these external elements, a range of internal factors, such as financial stability, productivity, innovation, risk management, diversification, compliances, etc., can also have an impact on a company's stock price. It should be understood that valuation is therefore never consistent.

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