A critical aspect in arriving at the fair target price for a stock is the choice of the valuation method. There are various methods for stock valuation. These include the Discounted Cash Flow (DCF) valuation and Price/Earnings, Price/Book value and Enterprise Value/EBIDTA multiples.
Let us discuss them one by one. The Discounted Cash Flow model discounts future cash flow projections using the weighted average cost of capital and forecasted growth rate.
Intrinsic Value = Terminal Cash Flow/ (Weighted average cost of capital-growth rate)
However the model is based on the assumption that the company will continue to grow at a particular growth rate forever. This may hold good for companies that have reached maturity phase but not in case for companies that are still in the expansionary phase. While two-step DCF model addresses such companies but it still involves a lot of assumptions. And any error in making assumptions can result in a faulty valuation. Therefore, in general the success ratio of the DCF model has not been very good.
A relatively simpler technique is the Price/Earning (P/E) multiple based valuation. It is based on the premise that a stock fluctuates around a threshold or equilibrium value. While in the short term, the stock price may swing wildly but in the long term it always comes back to the threshold value. The threshold value remains largely constant unless change in industry dynamics or company fundamentals deems a structural re-rating. This method also allows for qualitative evaluation by considering the P/E multiples of various companies operating in a sector and arriving at the most comprehensive valuation multiple for a company under consideration.
The major drawback for the P/E method is that it relies on earnings to arrive at the target price. If for some reason a company's earnings are volatile then it cannot be used as a fair indicator. This is particularly true in case of capital intensive sectors such as automobiles and engineering where companies entail large depreciation outflow in some years rendering earnings in those years unsuitable for long term comparison. Even in case of project-driven sectors such as infrastructure and real estate, the flow of earnings is erratic making P/E valuation method unsuitable. These companies are valued on the basis of Price/Book value (P/BV) multiple. Also in case of banking companies, which are in the business of lending, the capital or networth is far more important than earnings for the running of future operations. Therefore banking companiesare also valued on the basis of P/BV method.
The last valuation method is EV/EBIDTA and is used in case of overleveraged companies. When a company is saddled with huge debt, it makes sense to factor in the huge liability risk vested in it. Therefore such a company is valued on the basis of its Enterprise Value or the price to be paid to acquire the business along with its debt. The enterprise value is defined as,
Enterprise Value= Market Capitalization + Debt - Cash
Therefore the valuation multiple used in such case is Enterprise Value/Earnings before interest, depreciation, tax and amortization viz EV/EBIDTA.
You can study companies based on their valuation by logging into ResearchPro and clicking on 'Query on your own' on the Stock Screener section. Then in Stock Screener Module, you can choose sector and enter P/E or P/B valuation multiple in the respective drop-down menus. After this you enter >= or <= from the drop-down menu and appropriate multiple required in the text box and run the query. For example you can run the query to know the Top 10 IT companies whose 1yr forward P/E multiple is less than 20.
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