How to do the relative valuation of stocks?
“A great company is not a great investment if you pay too much for the stock.“
– Benjamin Graham, father of value investing.
Valuation is one of the most important aspects of investing in stocks. You might be able to find a good company, but if you not evaluating its price correctly, then it might turn out to be a bad investment.
There are two basic ways to do the valuation of stocks:
- Absolute valuation
- Relative valuation
The absolute valuation tries to determine the intrinsic value of the company based on the estimated free cash flows discounted to their present value.
The discounted cash flow model (DCF) is the most common approach for the absolute valuation.
However, there are few limitations of using absolute valuation as you will require to make few assumptions and the results are only as good as inputs.
Nevertheless, this post is not focused on the absolute valuation and we’ll discuss more in another post where you will require to understand a lot of complex terms like future free cash flow projections, discount rate (weighted average cost of capital- WACC) etc to find the estimated present value.
In this post, we are going to discuss how to do the relative valuation of stocks.
Relative valuation of stocks is an alternative to the absolute valuation.
It’s an easier approach to determine whether a company is worth investing or not.
Relative valuation compares the company’s value to that of its competitors to find the company’s financial worth.
It’s similar to comparing the different houses in the same locality to find the worth of a house. Let’s say if most of the 3BHK apartment in a locality costs around 70 lakhs and you are able to find a similar 3 BHK apartment which costs 50 lakhs, then you can consider it cheap.
Here, you do not find the true worth of the apartment but just compare its price with the similar competitors.
Tools for the Relative valuation of stocks:
There are a number of financial ratios that you can use to do the relative valuation of the Indian stocks. Few of the most common ones are described below:
1. Price to earnings (PE) ratio
This is one of the most famous relative valuation tool used to investors all across the world.
The concept of PE ratio is described beautifully in the Benjamin Graham’s book “THE INTELLIGENT INVESTOR”, which Warren buffet considers as one of the best book ever written on investing. I will highly recommend you to read this book.
PE ratio is calculated by:
P/E ratio = (Market Price per share/ Earnings per share)
However, PE ratio value varies from industry to industry, therefore always compare the PE of companies only in the same industry.
As a thumb rule, a company with lower PE ratio is considered under-valued compared to another company in the same sector with higher PE ratio.
2. Price to book value (P/BV) ratio
The book value is referred as the net asset value of a company. It is calculated as total assets minus intangible assets (patents, goodwill) and liabilities.
Therefore, Price to book value (P/B) ratio can be calculated using this formula:
P/B ratio = (Market price per share/ book value per share)
As a thumb rule, companies with lower P/B ratio is undervalued compared to the companies with higher P/B ratio. The P/BV ratio is compared only with the companies in the same industry.
3. Return on equity (ROE)
It is the amount of net income returned as a percentage of shareholders equity. ROE can be calculated as:
ROE= (Net income/ average stockholder equity)
It shows how good is the company in rewarding its shareholders. A higher ROE means that the company generates a higher profit from the money that the shareholders have invested. Always invest in companies with high ROE.
How to estimate the relative value of stocks?
For estimating the relative value of stocks, you need to set an accurate benchmark. The companies that you are comparing should be from the same industry and it’s even better if they have similar market capitalization (for example, a large-cap should be compared large-cap companies).
Let’s say that there are 5 companies in an industry and the average price to earnings ratio of the industry turns out to be 20.
Now, if the price to earnings value of the company that you are validating is 15, then it can be estimated to be relatively cheaper compared to the stocks in the same industry.
Similarly, you can use multiple financial ratios to find the relative value of the stocks.
Limitations of relative valuations:
No valuation technique can be perfect. There are few limitations of relative valuations which are discussed below:
- The relative valuation approach does not give an exact result (unlike discounted cash flow) as this approach is based on the comparison.
- It’s assumed that the market has valued the companies correctly. If all the companies in the Industry are overvalued, then the relative valuation approach might give a misleading result for the company which you are investigating.
Where to find the relative multiples for comparing Indian stocks?
I’ve already discussed most of these websites in my earlier posts. You can read more about them here.
In this post, I’m going to converse about a new website which I hadn’t discussed in any of my earlier articles. It’s Equity Master.
Equity master is an amazing website for stock research. While researching a company, you can get its 5-year data from the factsheets.
Similarly, if you want to compare two companies, this option is all available on the Equity master.
Just go on ‘Research it’ on the top menu bar and click on ‘Compare company’. Enter the name of the two companies and you’ll get the comparisons.
Here is the result that you will get if you compare Hindustan Unilever with Godrej Consumers:
It’s an amazing website. Just play around and get familiar with the website.
Relative valuation of stocks is a good alternative to the absolute valuation. You can use this approach for a simple yet effective stock picking.
If you want to learn how to invest in Indian stock market from scratch, feel free to check this amazing online course for beginners- “HOW TO PICK WINNING STOCKS?” The course is currently available at a discount.
That’s all for this post. I hope it is useful to you.
Please comment below if you have any questions. I’ll be happy to help.
Tags: Relative valuation of stocks, relative valuation steps, relative valuation advantages, relative valuation model