How to evaluate a stock?

The question remains whether or not your stock has been priced correctly. With the help of three evaluation ratios, one can successfully measure how expensive a stock is.

When it comes to the stock market, merely identifying a good business is never enough. One also needs to make sure that stocks are evaluated correctly. One needs to assess the value and worth of a business so that it is easy to determine whether or not the price you will pay for it is reasonable. Smart investors always want to buy a business when it is available at a price lesser than what it is worth. Even if a business is really good, if you pay too much for the stock, there are high chances that you will not get meaningful returns from it. And in the worst-case scenario, you might even lose precious money.

How then, do you assess valuations? Even though we do have tools to assess valuations, there is no one specific formula that applies to different cases. This criterion of evaluation varies from industry to industry. For example, FMCG stocks can still trade at comparatively high multiples, while metals and mining stocks will trade at low multiples.

At the same time, all this is also a matter of one’s analytical judgment. No one can always tell whether or not they are paying the correct price. For example, a company which is burdened with debt might be available at cheap valuation multiples, while a company which has good earning will trade at high valuations. Thus, valuations are contextual and cannot be seen in isolation. They need to be evaluated taking into consideration the quality of a business and other intrinsic aspects.

The economic potential of a country will also lead to certain variations. Naturally, a country that has high growth rates, alongside economic and political stability, will have higher valuations as compared to a country that is still struggling to hold itself firmly. Therefore, developed markets like that of the States trade at high valuations, thanks to their economic stability.

In essence, while assessing evaluations, the main motto is as follows: you want to buy only the good stocks at reasonable prices, neither do you want to buy the bad ones for cheaper rates, nor do you want to pay exorbitant prices for the good ones.

Here are three different tools that are used to evaluate stocks: 

Price to Earnings Ratio or the P/E Ratio:

This is the most widely used of all different valuation tools. It tells you how much you are paying for every rupee that the company earns. Let us say you buy a stock at a P/E of 10. This means that you are paying INR 10 for every single rupee of the company’s earnings. Therefore, naturally, you will want to pay as little as you possibly can. However, make sure that you study the business well before applying any valuation measure to it. A lower ratio does not always mean a good bargain. Similarly, a higher ratio does not always signal a bad deal or expensiveness.

Price to Book or P/B Ratio:

This ratio helps you to determine how expensive a stock is, about the worth of the stock in the books of the company. A ratio that is greater than one means that the stock is quoting at a premium as compared to its actual worth.

It is necessary to explore both the higher and lower ends of this ratio. A stock trading lower than its book value could be a ‘value trap’. This means that its cheap valuations are a result of its bad fundamentals. On the other hand, the book value is often unable to capture the true worth of the assets of a company. In such a case, the ratio might appear to be artificially high.

Price to Earnings Growth or PEG:

The PEG ratio is a modification of the traditional P/E Ratio. The legendary investor Peter Lynch popularized this approach. The ratio factors in the earnings growth rate, and can be obtained by dividing the P/E ratio by the earnings growth rate of the company. As a general thumb rule, a PEG which is less than one is considered to be attractive.