In the stock market, identifying a good business is not enough; buying the stock at the right valuations is as much important. Valuing a business means assessing its worth so that you can know if the price you are going to pay for it is reasonable. Smart investors want to buy a business available at less than what it's worth. If you pay too much for the stock, no matter how good the business, it's likely that you will not make meaningful returns or, worse, lose money.
How do you assess valuations? While there are some tools available to assess valuations, there is no one definite formula that you can apply to all cases. In fact, valuation criteria may vary from industry to industry. For instance, while it's okay for FMCG stocks to trade at comparatively high multiples, metals and mining stocks tend to trade at low multiples.
Assessing valuations is also a matter of analytical judgement. You can't always tell whether you are paying the right price. For instance, a debt-laden company may be available at cheap valuation multiples and a company with good earnings visibility may tend to trade at high valuations. Hence, valuations can't be seen in isolation; they should be viewed in conjunction with the quality of a business and its various intrinsic aspects.
Valuations also vary with the economic potential of a country. A country with high growth rates and political and economic stability will have higher valuations than a country which is struggling to hold itself together. A developed market, like the US, will trade at high valuations, given its economic stability.
Overall, assessing valuations is like buying vegetables: you want to buy the good ones at a reasonable price; you don't want to buy the bad ones cheap; and you avoid buying good ones at exorbitant prices.
Here are three popular valuation tools that can help you get an idea of how expensive a stock is:
Price-to-earnings (P/E) ratio: The P/E ratio is perhaps the most widely used valuation measure. It tells you what you are paying for every rupee of a company's earnings. If you buy a stock at a P/E of 10, it means that you are paying Rs 10 for the company's earnings of Rs 1. Naturally, you will want to pay as less as possible. But here is a word of caution. As stated above, study the business before applying this valaution measure to it. A low P/E doesn't always indicate a bargain and a high P/E doesn't always signal expensiveness.
Price-to-book (P/B) ratio: The P/B ratio tells you how expensive a stock is in relation to its worth on the company's books. A P/B ratio of over one means that the stock is quoting at a premium to its actual worth.
Both a high P/B and a low P/B should be explored. Don't get too excited to find a stock trading below book. Such a stock could be a 'value trap', i.e., it's cheap valuations are due to its bad fundamentals. On the other hand, sometimes the book value doesn't capture the true worth of a company's assets, which can make the P/B look artificially high.
The P/B ratio is especially useful in the case of banks and non-banking finance companies.
Price-to-earnings growth (PEG): The PEG ratio is an improvement on the traditional P/E ratio. Popularised by the legendary investor Peter Lynch, it factors in the earnings growth rate. It is obtained by dividing the P/E ratio by the earnings growth rate. A PEG of less than one is considered attractive.