How To Tell If A Stock Is Expensive

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How to tell if a
Know how to assess the actual value of a stock

through various popular measures like
P/E, P/B, PEG, etc.
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Contents
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Introduction
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Understanding the P/E ratio

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Understanding the P/B ratio

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n n n n n n n n n Understanding enterprise value

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Understanding
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discounted cash flow (DCF)
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Understanding the PEG ratio
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Introduction
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I
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f you think that you can make purchase decision is made, a
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growth stock, then think again. subconsciously. And things are not
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n n n n n n n n n Even if you buy a fabulous business very different in the financial world.
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that consistently grows its profits, you While the characteristics of the
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n n n n n n n n n are unlikely to earn returns on your objects purchased are different, the
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investments if you paid a fortune on fundamental requirements to conduct
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n n n n n n n n n purchasing the shares. This is precisely a valuation exercise remain the same.
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why it is important to purchase a So, let’s discuss some of the tools used
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whether markets are rising or falling, better investment decisions. There
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n n n n n n n n n the importance of understanding are broadly speaking two categories

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valuation will never fade away. of valuation techniques: absolute and
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n n n n n n n n n So, what is valuation? It is the relative. Absolute valuation

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science and art of estimating the true techniques, as the name implies,
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n n n n n n n n n worth of an asset. While this may attempt to put a rupee value to a

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sound complicated, it is actually particular asset, whereas relative
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n n n n n n n n n something that we regularly do in our valuation techniques are used to

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daily lives. Just like how housewives compare prices of other assets to see
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and will avoid purchasing expensive undervalued. Absolute valuation
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n n n n n n n n n vegetables, retail shoppers are also techniques include DCF, enterprise

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more likely to purchase items when value etc., while relative valuation
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n n n n n n n n n they are on sale. Every time a techniques include P/E, P/B, P/CF, etc.
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How to tell if a stock is expensive
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Understanding
the P/E ratio
The P/E ratio is the most common valuation tool. But it’s not
flawless. Here is all you must know about it.
“Price is what you pay, but would pay for every rupee of profits earned by
the company.
value is what you get.” We can illustrate it with an example. For
Warren Buffett example, if a company’s share price is Rs 1,500,
with its earnings per share being Rs 100, then it
P
rice-to-earnings ratio (P/E) is one of the can be said to be trading at a P/E ratio of 15.
most widely used valuation methods. This The numerator is either the price per share or
ratio shows how expensive a company’s the market capitalisation of the entire company
share price is as compared to its earnings. In and the denominator is either the earnings per
other words, it is the amount of money you share or the total earnings of the company.
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(Kindly note that by earnings, we differentiate between one-time

The P/E ratio
are referring to profits or bottom line earnings (such as the sale of a factory)
instead of sales or top line). Besides, can be used to and regular earnings (operational
estimated earnings of the next year compare stocks profit which is likely to recur in the
can also be used as an input. future). Also, this ratio varies in
across all
companies which are operating in
Advantages sectors, cyclical industries. Since the earnings
The P/E ratio gives a very quick and market of these companies follow a cycle, the
intuitive value that can be used to P/E ratio looks optically lower during
capitalisations
compare stocks across all sectors, up-market phases of the cycle and
market capitalisations and time and time seemingly high during down-market
periods. It is easy to compute and periods. phases of the cycle.
widely available on most financial Last but not least, this ratio is not
websites. applicable when a company does not make
profits. Since a negative P/E is meaningless (no
Disadvantages conclusion can be drawn from the magnitude
Even though the numerator, which is the share of the negative P/E), this metric cannot be used
price, is easily understandable, there are to value startups (which generally make losses
different variations in the denominator i.e for quite some time before they start making
earnings. Since earnings is an accounting profits) or mature companies which made losses
measure, it can be manipulated by the due to one-time events such as the write-down
company’s management in various ways. of a goodwill or inventory losses.
Another problem is that the P/E ratio does not
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Understanding
the P/B ratio
The P/B ratio is a classic tool to assess valuations, especially when
the P/E ratio is not useful. Here is all that you need to know about it
V
aluation metrics refer to the tools used can make well-informed decisions.
to evaluate the financial strength of The price-to-book ratio (P/B ratio) is a
companies and are computed by commonly used tool by value investors. Unlike
making calculations using the data disclosed in the P/E ratio which mainly focuses on a
the balance sheet, income statement and cash- company’s earnings, the P/B ratio looks at how
flow statement. These ratios assess companies’ expensive a company is as compared to its assets
profitability, liquidity, operational efficiency and (after paying off its liabilities). It is computed by
stability, thereby providing investors with dividing the price per share (or the company’s
in-depth information on companies. By market capitalisation) with the book value per
leveraging the power of ratio analysis, investors share (or the company’s net worth).
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Let’s illustrate this with the ideas, human capital, distribution

The P/B ratio
example of company A, which has a networks and hard-to-value
share price of Rs 2000 and a book gives an easily intellectual property. While book
value of Rs 800. So, its P/B ratio is understandable value might have been extremely
2.5. This means that investors are relevant in the past when physical
picture of the
ready to pay Rs 2.5 for every rupee and tangible assets such as land,
of net assets owned by A. If a company’s factory, equipment and buildings
company is trading at a P/B of less valuation in were the primary assets required for
than one, this implies that investors running a business, its relevance is
relation to its
can buy one rupee worth of assets decreasing in the modern era when
for less than a rupee. net worth. the proportion of intangible assets is
increasing(ex: e-commerce firms).
Advantages Therefore, the P/B ratio of companies having
Similar to the P/E ratio, the P/B ratio gives an a greater proportion of intangible assets will
easily understandable picture of the company’s seem optically higher than those having equal
valuation in relation to its net worth. It is more amounts of tangible assets.
stable (since asset prices are not as volatile as Another drawback of this metric is that the
earnings) and can also be used to value value of assets is subject to management’s
companies which have not earned profits (start- discretion because entries like depreciation and
ups and companies going through liquidation). goodwill can be manipulated to either increase
or decrease the book value of assets.
Disadvantages Also, this metric cannot be applied to
However, this metric is based on the accounting companies having negative net worth. For
recognition of assets and therefore, does not example, many airline companies in India have
capture the true value of all the company’s a negative net worth. And this could happen
assets because the accounting system has not with startups as well as mature companies going
yet evolved to value intangible assets such as through a difficult phase.
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Understanding
enterprise value
Commonly used during mergers and acquisitions, enterprise
value gives a complete picture of the true ownership cost of a
company. However, it has its own limitations.
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aluation metrics are used to determine premise that both equity and debt capital of a
the true worth of a company. Shedding company should be taken into account for
light on the context of a company’s valuing a company appropriately.
share price, they help in assessing the company’s The enterprise value of a company is
investment potential. calculated by adding the company’s market
In the previous parts, we have discussed two capitalisation with the book value of all its debts
relative valuation metrics, P/E and P/B. Unlike and then, subtracting the cash available with
those two, the enterprise value approach is an the company. This is done in view of the option
absolute valuation metric and is based on the available with an acquirer wherein the cash can
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be used to pay off the company’s

By taking a And finally, in this metric, there is
debts to that extent. For example, if a very little scope for the management’s
company has a market capitalisation company’s debt accounting manipulation, as the
of 1,000 crore and a debt of 5,000 burden into book value of debt and the cash on
crore, along with cash amounting to
consideration, hand is easily verifiable.
600 crore, then its enterprise value is
5,400 crore. enterprise value Disadvantages
gives a complete A shortcoming of this approach is
Advantages picture of the that it does not consider the earnings
By taking a company’s debt burden potential of capital investments,
into consideration, enterprise value company’s true thereby making it difficult to
gives a complete picture of the true ownership cost. compare companies in industries
ownership cost of the company to a which have different margins or
potential acquirer. Hence, this metric is companies in different phases
commonly used during mergers and of growth.
acquisitions. Also, since it fails to recognise the realisable
Another advantage is that this metric can be value of assets, it is an inappropriate metric for
used for both loss-making companies and companies which are going to be liquidated
companies with a negative net worth (major (these companies tend to have assets that are
shortcomings of P/E and P/B ratios, respectively). very small in proportion to their debts).
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Understanding discounted
cash flow (DCF)
DCF, which is an indispensable tool to evaluate debt instruments,
is also useful in the equity world. Here is what it means.
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aluation metrics are used to strongest and easily understandable principles
comprehensively assess a company’s of finance - the time value of money. In simple
performance, financial health and words, this principle asserts that the worth of
future prospects. Not surprisingly, both one rupee is more today than tomorrow. Let’s
shareholders and creditors hold much interest take the example of a regular household
in these metrics. Like enterprise value, the DCF investment product, the ubiquitous fixed deposit
or discounted cash flow is an absolute valuation (FD). If you deposit Rs 10 lakh in your FD today
method, which means that the end goal is to at an interest rate of 6 per cent, then the worth
arrive at a specific rupee valuation. of your FD tomorrow would be Rs. 10,00,164.
The DCF method is based on one of the This extra Rs 164 is the additional amount that
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you have earned in one day. While are sophisticated ways (CAPM,
This method is
this is normally called ‘interest’ and WACC, Historical etc.) but one can
typically thought of only in the more suitable to even use a (reasonably) desirable rate
context of debt investments, the value stable, of return. And finally, when it comes
underlying principle of growth in the to estimating the terminal value,
mature
expected value of money is equally investors again have a choice
valid (with some modifications) in companies between using a complex method (
the world of equity investments. which are likely Gordon Growth Model) or the same
The DCF method is, in essence, a multiple as what the stock is currently
to pay a steady
reverse-engineering process, which being traded at.
considers a share as nothing but a stream of cash
stream of future cash flows. To put a flows. Advantages
value on this ‘stream’, investors The DCF is very strongly grounded in
begin with estimating both the quantum and theoretical finance. The principle of time value
the timing of these expected future cash flows. of money is widely accepted across the world
These include intermediary payments and can be applied for valuing both companies
(dividends, buybacks etc) and a terminal (based on dividends, free cash flows etc.) and
payment (when finally disposing of the shares). individual projects. Further, this method is more
After choosing a specific time frame, all that suitable to value stable, mature companies
investors have to do is to ‘discount’ these future which are likely to pay a steady stream of cash
cash flows by using an acceptable discount rate flows.
to arrive at a present value.
For example, let’s take a situation where the Disadvantages
investment time frame is three years, the The primary disadvantage is the number of
company is expected to pay Rs 10 per year as inputs that go into the model. All the three
dividends and the share price at the end of inputs - discount rate, intermediary cash flows
three years is expected to be Rs 300. Now if our and terminal value - are subject to different
expected rate of return is 18 per cent, then the underlying assumptions.
DCF method would give a current share price Another disadvantage is that the valuation
of Rs 204.3. This means that in order for us to calculated through this method is predominantly
achieve the targeted return of 18 per cent based on the terminal value, which is very
(provided all our assumptions turn out true), we difficult to predict. The actual terminal value,
shouldn’t pay a price more than Rs 204.3. which is only realised at the end of the investment
Paying anything more would decrease our period, will be heavily subject to the prevailing
returns and vice versa. market conditions at that time, making it even
Interestingly, when it comes to implementing more difficult to predict than the intermediary
the DCF method, different routes can be cash flows, which are themselves uncertain.
followed. To begin with, investors can decide But investors need to understand that
which payment to discount. Dividends and free investing is ultimately based on faith and the
cash flows are the usual favourites here. The expectation that a brighter future awaits those
next step is to estimate the discount rate. There who are brave enough to take the risk today.
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Understanding the
PEG ratio
The PEG ratio assesses companies having different growth rates
and gives a better picture of which company is more expensive
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f there are two identical companies which and this is inappropriate for comparing
are similar in every regard except that one companies which are in different stages of their
company is projected to grow at a higher life cycles. If two companies have the same P/E
rate than the other, then isn’t it natural for a ratio, it is likely that many people will reach a
rational investor to pay more for the high- very cursory (but incorrect) conclusion that
growth company? both these companies are trading at the same
This analogy underscores an important relative valuation. But we know that a declining
shortcoming of the P/E metric i.e it ignores company is not likely to repeat its earnings,
expected growth rates. The P/E ratio values all while the company in its growth phase is likely
companies based only on its historical earnings to increase its earnings in the future.
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To rectify this shortcoming of the

The PEG ratio is having different growth rates. PEG is
P/E ratio, the PEG or ‘price-earnings also more appropriate when a
to growth’ ratio was devised. This intuitively company’s future is unlikely to
metric adjusts a company’s P/E by understandable resemble its past. For example,
dividing the P/E with the company’s Reliance Industries is evolving: from
and gives
expected growth rate. In a sense, the being a pure-play petrochemical
metric tells us what the P/E is per investors a refiner in the past, it is more likely to
unit of expected growth. For quick way to be a technology/retailing giant in the
example, a company trading at a P/E
value companies future.
of 15 and having an expected
earnings growth of 20 per cent having different Disadvantages
would have a PEG of 0.75. growth rates. The fundamental problem with this
If a company has a higher PEG metric is the same that is inherently
ratio, it means that even after accounting for its embedded in every forward-looking estimate i.e
expected growth, it is more expensive than the the predictability (or the lack thereof) of the
one with a lower PEG. So, when used for future. The PEG ratio is highly dependent on the
companies having different growth rates, the estimates of earnings growth and we all know
PEG ratio gives a better picture of which that predictions about a company’s future
company is more expensive. The generally earnings, even those of experts/analysts/super-
accepted thumb rule is that a PEG of 1 implies smart people etc., are anything but accurate.
that a company is fairly valued. Anything less Another limitation of this metric is that it is not
than that is considered to be undervalued and very useful for those companies whose
vice versa. valuations are not driven by earnings growth.
For example, the book value would be more
Advantages relevant for companies that are going to be
Apart from being more refined than the P/E liquidated, real estate investment trusts etc.
ratio, the PEG ratio is also fairly straightforward Investors also have to be careful while relying
to calculate and is available on many websites. upon the PEG ratios from different sources, as
It is also intuitively understandable and gives there could be different values, with each
investors a quick way to value companies having different underlying assumptions.
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Conclusion
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T
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he above-mentioned metrics fretting over how precise their
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n n n n n n n n n are not, by any stretch, estimation is, investors should focus

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exhaustive. But regardless of on having a broad understanding of
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n n n n n n n n n which valuation method an investor whether a share is overvalued or

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decides to use, one must not forget undervalued. As written by
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n n n n n n n n n that it is still an estimate. Estimates Benjamin Graham in his seminal

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are, by their very nature, imprecise book, Security Analysis, you don’t
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n n n n n n n n n and vary from person to person, need to know the exact weight of a
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depending on their underlying person to come to the conclusion
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Know how to assess the actual value of a stock

Understanding the P/E ratio

Understanding the P/B ratio

n n n n n n n n n Understanding enterprise value

n n n n n n n n n money by simply investing in a valuation exercise is carried out

n n n n n n n n n business at a sensible price. And by investors on a daily basis to make

n n n n n n n n n the importance of understanding are broadly speaking two categories

n n n n n n n n n So, what is valuation? It is the relative. Absolute valuation

n n n n n n n n n worth of an asset. While this may attempt to put a rupee value to a

n n n n n n n n n something that we regularly do in our valuation techniques are used to

n n n n n n n n n fully know the value of a vegetable which one is relatively overvalued or

n n n n n n n n n vegetables, retail shoppers are also techniques include DCF, enterprise

(Kindly note that by earnings, we differentiate between one-time

Let’s illustrate this with the ideas, human capital, distribution

be used to pay off the company’s

To rectify this shortcoming of the

n n n n n n n n n are not, by any stretch, estimation is, investors should focus

n n n n n n n n n which valuation method an investor whether a share is overvalued or

n n n n n n n n n that it is still an estimate. Estimates Benjamin Graham in his seminal

n n n n n n n n n assumptions and biases. Rather than that they are obese!

To read more such

insightful articles, visit

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