INTRODUCTION

When it comes to investing in stocks, one of the most important questions every investor wants to answer is this: “What is this company truly worth?”

That question lies at the heart of stock valuation. Investors don’t just buy stocks based on their price. They look at value—what the company is fundamentally worth compared to its current market price. If the market price is lower than its actual value, it could be a good investment. If it’s higher, it might be overvalued. To estimate that value, investors use valuation methods. These methods help determine whether a stock is cheap, fairly priced, or expensive. In this blog, we’ll explore the top stock valuation methods used by professionals and simplified for beginners.

Why Stock Valuation Matters

Valuation helps you make smarter investment decisions. If you pay too much for a stock, even a great company can give poor returns. But if you buy a stock below its actual value, you can benefit as the market catches up to its true worth. Stock valuation is especially useful in long-term investing, where you’re looking for companies that will grow and return value over time.

1. Price-to-Earnings Ratio (P/E Ratio)

The Price-to-Earnings ratio is one of the most widely used valuation tools. It compares a company’s current stock price to its earnings per share (EPS). To calculate the P/E ratio, divide the market price of the stock by its earnings per share. For example, if a stock trades at 100 rupees and its earnings per share is 10 rupees, its P/E ratio is 10. A lower P/E may indicate a stock is undervalued, while a higher P/E might suggest the stock is expensive relative to its earnings. However, it’s important to compare a stock’s P/E with other companies in the same industry, as different sectors have different benchmarks.

2. Price-to-Book Ratio (P/B Ratio)

The Price-to-Book ratio compares a company’s stock price to its book value, which is what the company would be worth if all its assets were sold and liabilities paid off. To calculate the P/B ratio, divide the stock price by the book value per share. A P/B ratio below 1 may indicate that a stock is undervalued, especially if the company is financially healthy. This method is more useful for valuing asset-heavy businesses like banks, manufacturing companies, and real estate firms.

3. Discounted Cash Flow (DCF) Method

The Discounted Cash Flow method is a more advanced, but very powerful way to value a company. DCF estimates the present value of a company’s future cash flows. In simpler terms, it answers the question: “How much are all future profits of this business worth today?”

To use DCF, you forecast the company’s future free cash flows and then discount them back to the present using an appropriate rate like the Weighted Average Cost of Capital (WACC). This method requires more assumptions and data, but it’s one of the most accurate methods if done properly. It’s used by serious investors who want to go beyond simple ratios and get a deeper look at intrinsic value.

4. Price-to-Sales Ratio (P/S Ratio)

The Price-to-Sales ratio compares the stock price to the company’s revenues per share. It’s calculated by dividing the stock price by revenue per share. This method is often used for companies that are not yet profitable, especially in the technology or start-up space, where earnings may not be stable. A lower P/S ratio could indicate that the stock is undervalued relative to its sales. However, high sales don’t always mean profitability. So this method should be used along with others.

5. EV/EBITDA Ratio

EV stands for Enterprise Value, which is the market value of equity plus debt, minus cash. EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. The EV/EBITDA ratio is used to compare companies regardless of their capital structure (debt vs. equity). It’s especially useful for comparing companies across industries. This method is considered more accurate than P/E for companies with high debt or non-cash expenses, as EBITDA focuses on core operating performance.

6. Dividend Discount Model (DDM)

For companies that pay regular dividends, the Dividend Discount Model estimates the value of a stock based on the present value of future dividends. It works well for mature companies like utility firms or blue-chip stocks that have stable and predictable dividend payments. However, it is not suitable for companies that don’t pay dividends or whose dividend history is inconsistent.

Which Method Should You Use?

There is no single best method. Each has its strengths and weaknesses, depending on the company, industry, and available data. The P/E and P/B ratios are simple and easy to use but may not show the full picture. DCF is more thorough but requires more time and assumptions. EV/EBITDA is helpful for comparing capital-intensive companies. The Dividend Discount Model is great for income investors focusing on long-term dividend payouts. Ideally, investors use multiple methods to cross-verify and arrive at a balanced conclusion. This helps reduce the risk of overvaluing or undervaluing a stock based on just one factor.

Final Thoughts

Valuation is both an art and a science. While formulas and ratios give you the numbers, judgment and research help you understand what those numbers mean in the real world. As you continue your journey in stock investing, understanding these valuation methods will help you identify good opportunities, avoid overhyped stocks, and build a portfolio that stands the test of time. Remember, stock prices go up and down every day, but the true value of a company changes much more slowly. The goal is to buy at a price below that true value—and to do that, knowing how to value a stock is your most powerful tool.

Keep learning, stay patient, and invest wisely.