Valuation Techniques: What is a Stock Really Worth?
Warren Buffett famously said: "Price is what you pay. Value is what you get."
Imagine you want to buy a magical Golden Goose that lays one golden egg every year.
- Seller A asks for ₹10 Crores.
- Seller B asks for ₹1 Crore.
The "Goose" is the same. The "Price" is different. Valuation is the mathematical art of calculating exactly how much that goose is worth based on the price of gold and how long the goose will live.
The Golden Rule: Never buy a stock just because the price is low (₹10). Buy it because the Value is higher than the price.
1. The Two Main Types of Valuation
How do you find the "True Value" (Intrinsic Value) of a company? There are two schools of thought:
- Relative Valuation: Comparing the company to its neighbors. "This house is worth ₹50 Lakhs because the similar house next door sold for ₹50 Lakhs."
- Absolute Valuation (DCF): Calculating value based on the cash the company generates. "This house is worth ₹50 Lakhs because it generates ₹2 Lakhs rent every year for 25 years."
2. Relative Valuation: The Quick Check
This is the most common method. We use ratios to compare companies.
A. P/E Ratio (Price-to-Earnings)
How much are you paying for ₹1 of profit?
- Company A: Price ₹100, Profit ₹10. P/E = 10.
- Company B: Price ₹100, Profit ₹5. P/E = 20.
Verdict: Company A is "cheaper" because you pay less for the same profit.
B. P/B Ratio (Price-to-Book)
Useful for Banks and Asset-heavy companies. It compares Price to the "Net Worth" of the company. P/B < 1 usually means the stock is undervalued.
3. Absolute Valuation: Discounted Cash Flow (DCF)
This is the "Money Machine" method. It answers: "If I buy this entire company today, how much cash will it give me over its lifetime?"
The Concept of "Discounting"
Would you prefer ₹100 today or ₹100 after 5 years? Today, right? Because money today is worth more than money tomorrow (Inflation + Opportunity Cost).
DCF takes all future profits (year 1, year 2... year 10) and "discounts" them backward to calculate what they are worth
today
.
Formula (Simplified):
Intrinsic Value = Sum of (Future Cash Flows / Discount Rate)
If the DCF Value comes to ₹150, and the Stock Price is ₹100, the stock is Undervalued . Buy it!
4. Margin of Safety
Benjamin Graham (Warren Buffett's teacher) gave us this concept.
Calculators can be wrong. Your assumptions about the future can be wrong. So, you need a buffer.
- Calculated Value: ₹100.
- Margin of Safety: 30%.
- Buy Price: ₹70.
If you buy at ₹70, even if your calculation was slightly wrong, you won't lose money. This is the secret to safe investing.
5. Summary Checklist
1.
Don't look at Price alone.
Look at Valuation.
2.
Compare P/E
with competitors to see relative value.
3.
Understand DCF
logic (Future cash worth today).
4.
Always keep a Margin of Safety.
Never pay full price.
Frequently Asked Questions
What is the difference between Price and Value?
Price is what you pay to buy the stock. Value (Intrinsic Value) is what the stock is actually worth based on its assets and future profits. If Price < Value, it is a good buy.
What is Relative Valuation?
Relative Valuation compares a company to its competitors using ratios like P/E (Price-to-Earnings). If Company A has a P/E of 10 and Company B has a P/E of 20, Company A is relatively cheaper.
What is DCF (Discounted Cash Flow)?
DCF is an absolute valuation method. It estimates all the future cash a company will generate and 'discounts' it back to today's value using an expected rate of return. It tells you the 'fair value' of the stock today.