Stock prices vs company valuation: Is your stock worth it?

Read on to understand the relationship between stock prices and company valuation in the Indian context.

What drives stock prices?

Stock prices are driven by the forces of supply and demand. When more investors want to buy a stock than sell it, the share price tends to rise. When more investors want to sell the stock than buy it, the share price falls. Stock prices can change rapidly based on news, investor sentiments, earnings reports, economic conditions, and other factors that impact the demand for a stock.

Many factors unrelated to the company's fundamentals and intrinsic value can cause its share price to fluctuate. For example, high inflation might cause investors to sell stocks, driving down prices across the market. Or an optimistic economic forecast could spur a surge of buying activity, lifting prices. These forces impact all stocks, regardless of the actual performance or valuation of the underlying companies.

Understanding company valuation

To determine the true worth or valuation of a company, analysts examine financial metrics like:

• Earnings per share (EPS)
• Price-to-earnings (P/E) ratio
• Return on equity (ROE)
• Profit margins
• Sales and revenue growth
• Total assets and liabilities
• Cash flow

By studying the company's financial statements and operations, analysts gain insight into its overall financial health and growth prospects. A company's valuation reflects analysts' estimates of its ability to generate profits and free cash flow now and in the future. The intrinsic value of a stock is based on the company's expected future cash flows, discounted back to the present.

Differences between price and value

Often, a company's stock price differs from its intrinsic valuation. Shares may trade above or below what the company is really worth.

Reasons for mispricing include:

• Investor overreaction – After opening a demat account, many investors may get overexcited about a company's prospects, driving the share price up too high, or overreact negatively to bad news, depressing the stock too much. These mispricings should correct once investor enthusiasm or pessimism reverts to the mean.
• Limits to arbitrage - In an efficient market, arbitrageurs would buy undervalued stocks and short sell overvalued ones, correcting pricing errors. But arbitrage has risks and costs that limit its force in correcting mispricings.
• Imperfect or asymmetric information - Investors do not all have the same information. Some trade based on incomplete data or suffer from behavioral biases. Insiders may profit from having superior access to information.
• Irrational exuberance - At market peaks, investor enthusiasm can lift stock prices far beyond reason. Likewise, at market troughs, fear and panic can depress prices excessively.

The gap between price and value presents an opportunity for savvy investors to buy underpriced stocks and sell or avoid overpriced ones. Value investors look for shares trading substantially below their intrinsic worth.

Examining company valuation metrics

Here are some key metrics to analyse when valuing Indian companies and their stocks:

• Price-to-earnings ratio: The P/E ratio compares a stock price to the company's annual earnings per share. Lower P/E stocks are considered undervalued compared to peers with higher P/E ratios. The average P/E ratio can vary significantly by sector and industry.
• Earnings per share: EPS measures a company's net profit allocated on a per share basis. Growing EPS generally indicates improving business performance. Investors should look for steady EPS growth over time.
• Return on equity: ROE measures a firm's profitability relative to its shareholders' equity. ROE reflects how well the company uses investors' capital to generate profits. A higher ROE indicates greater efficiency.
• Price to book value: The price-to-book (P/B) ratio compares the company's current share price to its book value per share. Book value equals assets minus liabilities. A low P/B may signal an undervalued stock.
• Cash flow: Analysing metrics like free cash flow yield or operating cash flow gives insight into how much excess cash the company generates after running the business. Cash flow fuels expansion, acquisitions, dividends, and stock buybacks.
• Industry metrics: Compare companies to sector and industry averages and medians to gauge their relative valuation. Firms trading at significant discounts to peers may be good value plays.
• Historical multiples: Track how valuation metrics have changed over time and versus historical averages for clues to over or undervaluation. Reversion to the mean is common.
• Forecast drivers: Make assumptions and projections about key value drivers like sales growth, margins, capex needs and capital structure. Model how forecast changes impact intrinsic value.

Valuation methods

• Discounted cash flow analysis: Projects future free cash flows and discounts them back to the present to estimate intrinsic value. Sensitive to assumptions and forecasts.
• Comparable trading multiples: Compares ratios like P/E, P/B and EV/EBITDA to peer companies to gauge relative valuation. Depends heavily on choosing suitable peers.
• Precedent transactions: Analyses valuation multiples paid in recent acquisitions of similar companies. Can provide valuation floor, as strategic buyers often pay premiums.
• Leveraged buyout analysis: Models a hypothetical leveraged buyout purchase price based on reasonable leverage and return assumptions. Helps establish a baseline valuation.
• Historic valuation multiples: Looks at a company's own valuation levels over time to identify potential mispricings relative to history. Requires normalizing unusual periods.

No single method provides a perfect measure of intrinsic value. Investors should use multiple approaches and require a margin of safety when investing in the share market.

Special cases - Growth and cyclical stocks

For high growth companies like technology stocks, traditional valuation metrics often appear stretched. Investors are paying for the company's future potential rather than just near-term profits. Growth stock investors rely more on revenue growth, user metrics, market share gains and long runway. Cyclical stocks like materials and industrials see valuations expand and contract based on economic cycles. Earnings correlate strongly to GDP growth. Ratios appear elevated at cycle peaks and depressed at troughs when profitability normalizes.

Valuing IPOs and unprofitable companies

Newly public companies lack long trading histories. Pre-IPO private valuations serve as reference points. Revenue growth and user traction take priority over earnings. Unprofitable firms must demonstrate a viable path to profitability.

The bubble debate

Critics often allege that India's share market is experiencing a valuation bubble. The counter arguments cite India's positive fundamentals like demographics, growing middle class, reforms, maturing companies and under-penetration of products and services. While pockets of overvaluation likely exist, broad generalisations may be premature given the diversity of Indian stocks and sectors.

Technical factors like liquidity, retail investor participation and momentum can distort prices over short-to-medium periods. Nevertheless, over the long run, fundamentals win out and rational valuations prevail. Patience and discipline are rewarded most often.

(This article is part of DMCL Consumer Connect Initiative, a paid publication programme. DMCL claims no editorial involvement and assumes no responsibility, liability or claims for any errors or omissions in the content of the article. The DMCL Editorial team is not responsible for this content.)