Valuation of stock for investment?

By / November 30, 2021
Table of Contents hide
1 Introduction to valuation
2 Multiples based valuation
2.1 Multiples for valuing stocks
3 References
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Introduction to valuation

The valuation of a business is essential when we want to invest in a particular stock or business. It is always necessary to valuate the company before investing. We know that stocks are listed in the stock market, and values go up and down based on the demand and supply. When we believe that market is efficient, we don’t need to valuate. However, it is not always true, as sentiments sometimes drive stocks, and for that reason, we need to valuate the business before investing in it for the long-term.

It is believed that there is no such thing as a true value or correct value of a business. Moreover, the valuation is subjective, context and preference dependent.

Usually, sellers tend to value their assets higher than buyers of the same assets in the market. The resulting purchase or sale value is a function of which story is more believable. The believability is likely a function of reasonability and need. Suppose there is a sentiment that a particular business, story, or the stock may return higher in subsequent years. In that case, possibly more buyers will be willing to invest in that business, story, or stock.

To quantity the believability and reasonability of the story or business, we use numbers, equations, and logic.

  • When the price of an asset is higher than what the story suggests, the asset is called overvalued.
  • On the other hand, when the price of an asset is lower than what the story suggests, the asset is called undervalued.
  • The price of an asset is equal to what the story suggests, and the asset is fairly valued. 

In simple words, the valuation estimates can be as complicated or straightforward as we like. But, estimates should be relevant and reliable. If markets are efficient, there is no need to value any asset manually as the value of every asset would be determined by the market and easily accessible and viewable. However, when we attempt to valuate any stock, we do not believe markets are efficient. On the other hand, if we believe markets are efficient, we need to look up the value of a stock to see how much it is worth. 

Though we have mentioned that there is no true value, and valuation is subjective. However, it has been observed that when we decrease subjectivity, then reliability of valuation increases, and similarly, compared with the relevance of an estimate increases with respect to subjectivity. After a certain point, it starts decreasing. 

Multiples based valuation

Multiples-based valuation is one of the easiest and most common valuation techniques. It is also called Relative or Comparables based valuation. The method relies on multiples to determine the price of a stock or securities, etc. Multiples are factors used to estimate the value of a stock, and it is a kind of function that takes stock price and some drivers of value. An example of the drivers of value could be Earnings, Revenue, Book Values, etc.

Multiples are generally ratios, and they can be rearranged to expression for the price of a stock. And one of the most famous investor ratios is the Price to Earnings (P/E) ratio, where EPS stands for Earning Per Share and P stands for Stock Price.

\text{P/E} = \frac{\text{P}}{\text{EPS}}

The above equation can also be rearrange to know the price of an stock which is as follows:

\text{P} = \text{P/E} \times \text{EPS}

In general we can rewrite multiples valuation as follows:

\text{P} = \text{M} \times \text{DV}

Where P stands for Price of a stock, DV represents driver of value and M represents multiple. Here M used is of a comparable firm(s) instead of the one for the firm being valued.

Multiples for valuing stocks

To obtain a value for firm X, we would multply company Y’s P\E ratio with firm A’s EPS. It is represented in the following ways:

\text{P}_X = \text{P/E}_B \times \text{EPS}_A

In general we can represent it as follows:

\text{P}_X = \text{M}_Y \times \text{DV}_X

Where, \text{P}_X  = Price of a stock x firm, \text{DV}_X = driver of value of a firm x, and \text{M}_Y = Multiple of a comparable firm y.

The use of another firm’s multiple relies on the Law of One Price, that means, the law that any two assets with identical risk and rewards must have identical prices. However, in the real world, it is extremely difficult to find two perfectly identical stocks.

References

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“Valuation of a stock for investment” From NotePub.io – Publish & Share Note! https://notepub.io/questions/what-is-a-valuation-of-a-business-in-the-stock-market/

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