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Stock Valuation

Stock Valuation



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Published by Ankur Sharda
Broad way of making a judgement on investing in stock markets.
Broad way of making a judgement on investing in stock markets.

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Published by: Ankur Sharda on Dec 16, 2008
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- By Ankur Sharda, Author of ‘A Guide For Discerning Investor’ available on
Earning Growth
Average growth approximation: Assuming that two stocks have the same earningsgrowth, the one with a lower P/E is a better value. The P/E method is perhaps the mostcommonly used valuation method in the stock brokerage industry. By using comparisonfirms, a target price/earnings (or P/E) ratio is selected for the company and then the futureearnings of the company are estimated. The valuation's fair price is simply estimatedearnings times target P/E.Constant growth approximation: It assumes that dividends will increase at a constantgrowth rate (less than the discount rate) forever.
Limited high-growth period approximation
: When a stock has a significantly highergrowth rate than its peers, it is sometimes assumed that the earnings growth rate will besustained for a short time (say, 5 years) and then the growth rate will revert to the mean.This is probably the most rigorous approximation that is practical.
Market criteria (potential price)
Some feel that if the stock is listed in a well organized stock market, with a large volumeof transactions, the listed price will be close to the estimated fair value. This is called
theefficient market hypothesis
. On the other hand, studies made in the field of 
behaviouraleconomic or finance
tend to show that deviations from the fair price are rather commonand sometimes quite large. Thus, in addition to fundamental economic criteria, marketcriteria also have to be taken into account market-based valuation. Valuing a stock is notonly to estimate its fair value, but also to determine its potential price range, taking intoaccount market behaviour aspects.Once again to say that all theories are hypothetical and there are conditions applied to it.What can happen in unforeseen future nobody can tell and any estimates done for thefuture can be revised at any given point.One factor strongly affecting a stock’s price is
earnings growth
. All other things beingequal, if a stock’s earnings grow by 20% in a given year, we might expect the stock’sprice to also rise by 20% in order to maintain about the same P/E ratio. So before buyinga stock, we would like to get an idea of how earnings may grow in the next year, twoyears or more. One way would be to look up the analysts’ predictions on future earnings-per-share (EPS) in either free or fee publications. Upto the period of 2 to 3 years one canstill foresee the reasonable rise in EPS. One should always take into consideration onexpansion of company during boom, stable or bust time of a particular industry cycle.Backward integration is one way where company can reduce cost of inputs and boostprofitability whereas in the case of Forward integration, company can boost profit byselling finished goods to consumer.There is also one more important factor to consider is
extra ordinary item
(income orloss) in the balance sheet. It should be excluded while concluding the profits of acompany. Investor should be able to estimate the time of completion of expansion,
- By Ankur Sharda, Author of ‘A Guide For Discerning Investor’ available on
 restructuring, integration and various such factors which can affect the earnings of acompany in future. These are micro factors where one can do analysis in forecasting EPSfor the company. Stocks involved in commodity are comparatively easier to predict thenconsumer behavioural goods (like hotels, transportation, amusements, home appliances,automobiles etc.) because when the sentiment of consumer can change, nobody wouldknow, and it falls under behavioural economics.However, we all have read stories of analysts having historically been overly optimistic,having poor track records and being pressured by their employers to give high growthestimates for certain companies. What if the EPS is manipulated by the companiesthemselves? During boom times, all companies prefer good results so that their stock price will go up and they can raise money at minimum cost. After the meltdown of assetbubbles, several large companies found guilty of manipulating EPS, reports and suchother micro factors. Soon after the meltdown of NASDAQ, one of the top 5 accountancyfirms was involved with the management in manipulating the balance sheets. There arestill so many hidden facts which never came out. When the bear market persists that isthe time one can judge the real strength of financial health of the company.But if one has excelled, you can enter some simple formulas and become your own stock analyst. We are trying to predict the future just like the analysts, which is not easy.
Future projection of an asset price backed by valuation is nothing but speculation whereone is trying to predict the future based on knowledge.
But at least we know predictionswill only be based by one thing - the actual historical earnings of the company. With theproven track record of growth of average 20% per annum on averaging last 5 yearsearnings could help you determining the growth for next 5 years. Any analysts’ job is topredict future earnings where some times targets exceed their prediction or some timestargets go completely wrong. Well, when the target exceeds, nobody shall say a wordwhere he or she has failed in prediction because target has exceeded more thanexpectation, but in an otherwise case, he or she shall be condemned.Share prices in a publicly traded company are determined by market supply and demand,and thus depend upon the expectations of buyers and sellers.Among these are:1. The company's future and recent performance, including potential growth.2. Perceived risk, including risk due to high leverage.3. Prospects for companies of a particular industry, the market sector.By dividing the price of one share in a company by the profits earned by the company pershare, you arrive at the P/E ratio. If earnings move up in line with share prices (or viceversa) the ratio stays the same. But if stock prices gain in value and earnings remain thesame or go down, the P/E rises. The price used to calculate a P/E ratio is usually the mostrecent price. The earnings figure used is the most recently available, although this figuremay be out of date and may not necessarily reflect the current position of the company.This is often referred to as a 'trailing P/E', because it involves taking earnings from the
- By Ankur Sharda, Author of ‘A Guide For Discerning Investor’ available on
 last four quarters. The P/E ratio implicitly incorporates the perceived riskiness of a givencompany's future earnings.Variations on the standard trailing and forward P/E ratios are common. Generally,alternative P/E measures substitute different measures of earnings, such as rollingaverages over longer periods of time (to "smooth" volatile earnings, for example), or"corrected" earnings figures that exclude certain extraordinary items or one-off gains orlosses. The definitions may not be standardized.Various interpretations of a particular P/E ratio are possible and the historical table asfollows is just indicative and cannot be a guide, as current P/E ratios should be comparedto current scenario:
A company with no earnings has an undefined P/E ratio. As a normal practice,companies with losses are usually treated as having an undefined P/E ratio. Still anegative P/E ratio can be mathematically determined.
Either the stock is undervalued or the company's earnings are expected to be indecline. Alternatively, current earnings may be substantially above historic trendsor the company may have profited from extraordinary items.
For many companies a P/E ratio in this range may be considered fair value.
Either the stock is overvalued or the company's earnings have increased since thelast earnings figure was published. The stock may also be a growth story stock with earnings expected to increase substantially in future.
A company whose shares have a very high P/E may have high expected futuregrowth in earnings or the stock may be the subject of a
speculative bubble
.It is usually not enough to look at the P/E ratio of one company and determine its status.Usually, an analyst will look at a company's P/E ratio compared to the industry thecompany is in, the sector the company is in, as well as the overall market. Only after acomparison with the industry, sector and market can an analyst determine whether a P/Eratio is high or low with the previously stated distinctive table (i.e., undervaluation, overvaluation, fair valuation, etc).

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