In the stock market, picking the right business is not the only criteria to invest but at what price you should buy the stock is also very important. This is because even if you have identified a great business but have paid way more than it’s worth, then there are good chances that you will not be able to make healthy returns or may even lose money. This is where valuations come into picture and valuation methods become even more important.
So how do we value businesses?
While there are many available methods to assess the same, there is no definite answer on whether a particular valuation multiple is justified or not. This is because each sector is different and no two companies are exactly the same even if they are in the same sector. One of the most widely used valuation methods is price multiple which includes Price/Earnings, Price/Book Value, EV/EBITDA and Price/Sales. Price/Earnings is one the most common multiple which is used for most sectors including Auto, FMCG, Consumer Durables, Pharma, IT, and Capital Goods. For bank and lending companies, Price/Book Value is a more appropriate method as banks earn income based on their balance sheet size. For companies with high levels of debt, EV/EBITDA multiple is used for valuation. Metal and Cement sectors usually resort to EV/EBITDA multiple for valuation.
While Price multiples are good to use, it can sometimes be misleading as earnings per share isn’t always reliable and it is difficult to compare companies in two different sectors. For instance, an investor cannot assign the same value for Metal and FMCG stocks. Metal as we all know is highly cyclical and more vulnerable to economic conditions.
On the other hand, FMCG business is much less vulnerable to economic cycles. Hence, it would be justified to assign a higher multiple to FMCG stocks as compared to Metals. The alternate method which can be used is Discounted Cash Flow method wherein future cash flows are discounted based on projections to its present value to ascertain the fair value of the company.
(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)
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