How to Value a Stock in India: A Beginner's Guide

Learning How to value a stock in India correctly is a skill many novice investors do not fully master. Indian stock prices do not follow an absolute valuation logic. A stock trading at ₹500 has the same potential as a stock trading at ₹5,000. Fundamentals such as the quality of the business, earnings, cash flows, assets, and potential for long-term business growth and downside become the key components of determining stock valuation.

Stock valuation is beneficial to new investors for determining the company's market price versus the potential for its fundamental price or relative price. Some of the more common methods include Price-to-Earnings (P/E) Ratio, Price-to-Book (P/B) Ratio, Enterprise Value-to-EBITDA (EV/EBITDA), Discounted Cash Flow (DCF) Analysis, and Dividend-based valuation.

This guide provides a simple methodology for novice Indian equity investors to understand how to use stock valuation in conjunction with other metrics to ascertain stock value potential.

How to Value a Stock in India: Starting with the Business

Prior to evaluating a stock, it is imperative to understand the company's line of business. Valuation metrics and analysis have little value without a business context.

SEBI's investor education material writes that fundamental analysis can describe the financial and economic components of a business that can help determine the potential for a business to grow. It also describes the analysis of financial statements, economic conditions, and industry valuation metrics such as P/E and EPS.

When analyzing a company, investors should consider various factors relating to the company's business, competitors, sources of revenue, profitability, cash flow, and industry. SEBI also suggests examining the business, competitor analysis, and reviewing financial statements and valuation. SEBI's fundamental-analysis guide and SEBI's due-diligence guidance offer helpful references to investors for self-education.

What is Stock Valuation and What Does it Entail?

Stock valuation is the process of calculating how much a company's stock could be worth based on financial information, prices within the market, expected cash flows, company assets, accounts, and different assumptions.

There are two main ways to do valuation.

• Relative valuation: Relative valuation is comparing a company's valuation multiples against itself through history, competitors, or an industry standard.

• Intrinsic valuation: Intrinsic valuation is looking at the future cash flows, dividends, or other assumptions and calculating the value of the business.

A stock can be considered cheap based on one valuation method and expensive based on another. An example is that a company can have a low P/E ratio because its earnings are high for the moment, but in the future, earnings could weaken; whereas another company can have a high P/E ratio because investors believe the company will show strong earnings in the future.

1. Price-to-Earnings Ratio (P/E)

The Price to Earnings Ratio (P/E) is one of the more popular stock valuation techniques. It compares a company's share price with the earnings per share (EPS).

Formula: P/E = Market Price per Share / Earnings Per Share

For instance, if a company has a share price of ₹600 and EPS of ₹30, its P/E ratio calculations would be 20. This means that an investor pays ₹20 for every ₹1 of the current annual EPS.

The National Stock Exchange (NSE) states that P/E is the stock price to earnings per share ratio, and this ratio can be used to compare a company's stock to other companies in the same industry. NSE has added further information with their P/E methodology.

Understanding P/E

P/E ratio tells us the valuation of the company at a lower level. However, we shouldn’t view P/E ratio as a proxy for valuation. There can be weaker growth, higher debt, cyclical earnings, governance risk, and industry downturns, which can drive P/E ratios lower.

We may view a higher P/E ratio as the stock pricing in better growth opportunities combined with the quality of an investment and better return on investment (capital) and earnings visibility. Of course, it can mean that stock pricing is attractive in relation to future growth valuations.

To aid analysis, look at:

• P/E ratios for companies in different industries or segments

• P/E ratios for the company in the past

• P/E ratios which reflect the company’s growth opportunities

• Profit margins and return on equity

• Debt levels and quality of cash flow

2. Price-to-Book Ratio (P/B)

The price-to-book ratio (P/B) calculates how company shares are trading relative to book value, or shareholder equity summed with deductions attributable to liabilities.

Formula: P/B = Market Price Per Share / Book Value Per Share

Broadly, book value is the accounting value of equity after accounting for liability. NSE also publishes P/B ratios for market capitalization and reported net worth.NSE's P/B methodology explains the calculation at the index level.

P/B ratio is optimal for businesses for which balance sheet and asset base are economically important, such as financial companies.

However, book value does not reflect all the economic value of intangible assets and future growth. Therefore, it should be analyzed in combination with profitability and return on equity.

3. EV/EBITDA Valuation

Enterprise Value to EBITDA (EV/EBITDA) is a relative valuation method that compares a company's enterprise value to its EBITDA.

Enterprise value includes equity value and net debt, and EBITDA consists of earnings before interest, taxes, depreciation, and amortization.

Basic equation: EV/EBITDA = Enterprise Value ÷ EBITDA

This multiple can be especially helpful when differentiating companies with varying debt structures, since enterprise value equals debt plus equity.

Imagine two companies in the same industry that produce the same EBITDA. If one of them has a much higher EV/EBITDA multiple, perhaps there is a good reason for it and therefore investors will evaluate it more closely. The EV/EBITDA may reflect a premium that is warranted by a stronger growth rate or position in the market, stronger margins, or better cash generation, or it may reflect a premium that is too high.

EV/EBITDA poses some problems, as EBITDA is not equivalent to cash flow, since EBITDA does not include interest, taxes, capital expenditures, and changes in working capital. Therefore, analysis of capital-intensive companies is necessary.

4. Discounted Cash Flow (DCF) Valuation

Discounted Cash Flow (DCF) analysis calculates present value to determine value.

The present value of cash flows is greater than a cash flow that happens in the future, because money has a time value and future cash flows are uncertain.

A simplified DCF includes:

1. Estimate future free cash flows.

2. Determining a discount rate

3. Calculating a cash flow terminal value

4. Discounting future cash flows and terminal value to present value

5. Adjusting for debt and cash and other relevant factors to find an equity value estimate

6. Finding an estimate for value per share by dividing the equity value estimate by the total number of outstanding shares

NSE's equity research training module provides ample instruction on DCF analysis, free cash flow to firm, free cash flow to equity, terminal value, and cost of capital. NSE's equity research and valuation material provides a useful reference for these concepts.

Why DCF is Difficult to Learn

There are many variables that contribute to the sensitivity of DCF analysis and therefore, the answer. Changes to expected revenue, changes in operating margins, expected capital expenditure, discount rate changes, and terminal growth changes can each have a distinct impact on the DCF analysis.

For this reason, a DCF should always be communicated as a range of values, instead of as a singular answer.

5. Dividend Discount Model

The Dividend Discount Model (DDM) estimates the value of a share by using the present value of anticipated future dividends.

One model is the Gordon Growth Model:

Estimated value = Next year’s dividend ÷ (Required return - Dividend growth rate)

This model is more applicable to companies that have predictable and stable growth. Although, because some companies choose to retain their profits for growth, this model tends to be more applicable to companies that have an established dividend policy versus companies that grow through profit retention.

DDM becomes less applicable when a company’s dividends become irregular, when a company retains almost all profits, or when the growth and required return assumptions become highly subjective.

Stock Valuation Methods Compared

How to Determine If a Stock is Overvalued or Undervalued

Figuring out whether a stock is considered overvalued or undervalued is rarely straightforward. However, there are multiple ways to analyze data to better understand current and historical company performance within the industry.

Step 1: Check the Company's Earnings

First, examine the a company’s revenues, operating profits, net profits, and EPS. Check to see the trend and quality of profits rather than focusing on one quarter’s earnings.

Additionally, consider whether cash flow or cash profits are directly supporting the profits. If a company is showing profits with no cash inflows, that is a red flag.

Step 2: Compare With Industry Peers

Compare P/E, P/B, EV/EBITDA and other relevant metrics with businesses that have reasonably similar economics.

A technology company should not automatically be compared with a bank simply because both are listed equities. Sector economics, capital intensity, regulation, margins and balance-sheet structures differ.

Step 3: Check the Company’s Historical Performance

Current PE may be well above or below historical PE. However, when doing historical comparisons, consider the difference in the growth and structure of the industry. Also, take into account the change in the quality of the company’s operations and the allocation of the company’s capital.

Step 4: Consider the Growth Expectations for the Company

A company that is growing rapidly may fetch a premium valuation; however, a rapidly slowing business may receive a low valuation.

The most important question is not, “Is the P/E high?” The appropriate question is, “What future performance is reflected in the current price?”

Step 5: Check Debt and Cash Flow

Companies with similar P/Es can have drastically different financial concerns. Research debt ratios, costs of interest, operating cash flow, capital expenditures and free cash flow.

Step 6: Consider Management and Competitive Position

Financial ratios constrain the analysis of management quality, corporate governance, competitive advantages, disruptive potential of businesses, and the risks associated with regulations. These factors can be important for establishing intrinsic value.

A Simple Example of Stock Valuation

Imagine an Indian company with the following things:

• Share price: ₹500

• EPS: ₹25

• Book value per share: ₹125

• EBITDA per share equivalent: ₹50

With these numbers, P/E would be 20, and P/B would be 4. With these numbers, we can't make a value judgment on whether the stock is cheap or expensive.

For example, if other firms that are similar trade in this range of P/E multiples, between 25 and 30, and if they share the same or similar growth and profitability and risk characteristics, then this company may seem inexpensive. But if the company is expected to have a rapid downturn in earnings, then the lower multiple may be justified.

With a P/B of 4, this may seem high for an asset-intensive company. However, this may be reasonable for a company with higher returns where book value may be a poor reflection of the economics of the business.

This is the nature of valuation.

Common Stock Valuation Errors

• Using P/E alone: Using only one ratio will not provide enough insights.

• Comparing unrelated businesses: Valuation multiples differ across sectors.

• Ignoring debt: High leverage can offset the low P/E.

• Using One-Year Earnings in Isolation: Cyclical or Extraordinary profitability can distort valuation.

• Thinking that a low price means a cheap valuation: A ₹100 stock might be considered more expensive than a ₹2,000 stock.

• Treating DCF output as exact: DCF depends heavily on assumptions about future performance.

• Ignoring cash flow: Accounting profit and cash generation can differ materially.

• Ignoring the Qualitative Aspect: Governance, competition and disruption, and industry changes are critical.

Information On Valuations for Indian Investors

Exchange disclosures, annual and quarterly reports and investor presentations are some of the first level analysis that investors can undertake. NSE company pages can provide information on the markets and valuation as well as P/E ratios and some financial data for listed securities.

For regulatory and protective measures for investors, the primary source is the SEBI investor portal. In addition, investors can find listed-company disclosures and exchange information on the official websites of the BSE and NSE.

Investors should prioritize primary disclosures and audited financial statements over social media and other stock tips.

Valuation Is Not the Same as Predicting the Share Price

An estimated fair value should not be confused with a future share price. It can take a long time for a market to trade within estimated value or for a market to trade above or below an estimated value.

Just identifying an undervalued company is not sufficient. It can take time for markets to recognize the value. Likewise, a company that appears to be overvalued can continue to command a premium if its future earnings growth outpaces expectations.

Valuation should thus be considered with business quality, financial strength, growth, and risk trade-offs.

Investors interested in developing a more comprehensive fundamental analysis framework can also refer to our guide on the fundamental analysis of stocks.

How to Value a Stock in India: A Practical Checklist

1. Analyze the business model.

2. Check revenue, earnings, margins, and EPS.

3. Review operating cash flow and free cash flow.

4. Review the debt. Also consider the cost of interest and the strength of the balance sheet.

5. See how P/E multiples compare to other companies and see how they have compared historically.

6. Use P/B for companies where the book value is economically significant.

7. When looking at companies that operate, consider EV/EBITDA.

8. Use a DCF approach or a dividend valuation model when you can rationalize some of the key drivers.

9. Run a scenario analysis around these key drivers, with a conservative, baseline, and optimistic case.

10. Determine if the stock is fairly valued based on expected earnings growth, considering the other strategic factors.

11. Check the quality of the ownership and the competitive and regulatory environments.

12. Base your decisions on your own goals, not solely the valuation.