We all perform some kind of valuation in our day-to-day life. Simply put, when buying a product or service, this question often pops up in our head “Does the product/service give me back enough in return for the money that I am paying?”. Similarly in investing, the question is “Are you getting enough future returns (dividends &/or capital appreciation) for the risk that you are taking by investing your hard-earned money in that company?”. Investors have used various methods and ratios to arrive at the answer to this question. All these methods and ratios combined together form the universe of valuation. While it is almost impossible to describe and elaborate on all the valuation methods here, an investor will do well to learn a few of the widely used methods and ratios like the DCF method, P/E ratio, P/S ratio, P/B ratio, PEG ratio, Return Ratios, etc.

Discounted Cash Flow (DCF): In this method, the investor discounts (computes present value) all the future cash flows to their present value and arrives at a sum total of that present value. If that present value is higher than the value indicated by the current share price, the stock is said to be undervalued and vice versa. This is one of the most widely used, studied, and taught methods of valuing a stock. A major drawback of the DCF method is that it is heavily dependent on the assumptions and inputs to arrive at the final number. However, if done correctly, it can form an anchor point for an investor’s valuation toolkit. 

Price to Earnings (P/E) ratio: This is one of the most widely used ratios for arriving at a quick valuation of the company. To calculate the P/E ratio, the price per share of the company is divided by the annual earnings per share (EPS) of the company. A P/E ratio of 20 means that it will take the company 20 years to earn as much money as the current share price of the company (assuming the company earns the same EPS every year). A P/E ratio should never be looked at in isolation. When considering the P/E ratio, an investor should always consider other factors like the growth rate of the earnings, stability of the earnings, dividends that the company is paying, the industry, etc. P/E ratios should not be compared across companies operating in different industries because the industry dynamics at play are completely different. 

PEG ratio: Dividing the P/E ratio of the company with the annual earnings growth rate gives you the PEG ratio. As a general rule, a PEG ratio of less than 1 is considered to be very good. 

Price to Sales (P/S) ratio: To calculate the P/S ratio, the price per share of the company is divided by the annual sales (revenue) per share of the company. Again, comparing the P/S ratio across industries is not advisable. 

Price to Book value (P/B) ratio: Dividing the price per share of the company with the book value per share of the company gives you the P/B ratio. The major drawback of this method is that it does not capture the right value of intangible assets like patents, brands, intellectual property, etc. And the companies of today, especially tech companies derive a lot of their value from these intangible assets. Hence, the P/B ratio is not as relevant in today’s world as it used to be around 50 to 100 years ago.

Return Ratios: Few of the popular return ratios that investors monitor are ROE (Return on Equity), ROA (Return on Assets), and ROCE (Return on Capital Employed). Learn what they mean, how to calculate them, and when to use them. For different industries/sectors, different return ratios take significance. Typically, return ratios should be compared across companies from the same industry or against the company’s own past, but not against companies operating in different industries/sectors.

As mentioned earlier, this is just a starting point. There is a lot more to learn about valuation than what is described here.