Valuation of Shares: Meaning, Methods, & Types, and Factors (2024)

Home » Stock Market » Valuation of Shares: What You Need to Know Before Investing

How do investors decide whether a stock is worth buying, selling, or holding? What are the different methods and factors that influence the valuation of shares?

Let us take a look at the concept of valuation of shares and see why it is important for any person planning to jump into stock market investing.

Valuation of shares is the process of determining the fair value of a company’s shares.

The “fair price” of a share refers to the price at which the stock is neither overvalued nor undervalued.

It represents the equilibrium point where the supply and demand for the stock are balanced. This equilibrium is achieved by considering all available market information and conditions.

Valuation of shares is important for investors, analysts, and companies.

It involves using quantitative techniques and financial data to assess the company’s performance, growth potential, risk, and competitive advantage.

Let us understand the concept in a simple way:

Imagine you own a bakery, and you want to sell a part of it to your friend.

You both agree on a price for a share of the bakery.

That price is based on how much your bakery is worth. It can include things such as equipment, reputation, and how much money it makes.

In the stock market, it’s similar.

When a company decides to sell a piece of itself to the public, they divide it into shares.

The price of each share depends on how much the company is worth.

Investors consider a company’s profits, growth potential, and industry trends to decide if they want to buy shares and at what price.

There are different types of valuation of shares, depending on the perspective and purpose of the valuation.

• Intrinsic value: This is the true or fair value of the shares. It is based on the fundamental analysis of the company’s financial performance, risk, and future prospects.

It is independent of the market price and reflects the intrinsic worth of the company.

• Market value: This is the current or prevailing price of the shares in the market.

It is based on the market forces of demand and supply.

• Relative value: This is the value of the shares relative to other comparable companies or assets in the same industry or sector.

It helps to assess the relative attractiveness of the shares.

• Book value: This is the value of the shares as recorded in the company’s balance sheet.

It represents the net worth of the company from an accounting perspective.

• Liquidation value: This is the value of the shares if the company is liquidated and its assets are sold at their market value.

There are different methods of valuation of shares.

You can choose one based on the purpose, data availability, and assumptions.

Net Asset Method

This method values the shares based on the net assets of the company, i.e., the difference between the total assets and the total liabilities.

It assumes that the company can be liquidated and its assets can be sold at their book value or market value.

This method is suitable for capital-intensive companies or companies that are going to be dissolved or merged.

This method looks at how much profit each share of a company is making.

If a company is making a lot of profit per share, its shares might be more valuable.

Earning per share helps calculate the stock value and profitability of a company.

Price-to-Earnings (P/E) Ratio

This ratio compares the price of a company’s shares to its earnings per share.

A high P/E ratio could mean investors expect high growth from the company.

On the other hand, a low P/E ratio might indicate that investors are cautious about its future prospects.

Dividend Discount Model (DDM)

This method focuses on the dividends a company pays to its shareholders.

It estimates the present value of all future dividends to determine the value of a share today.

Discounted Cash Flow (DCF)

DCF looks at how much cash a company is expected to generate in the future and discounts it back to its present value.

It considers factors like future profits, expenses, and investments.

It’s like figuring out the current value of all the money your bakery is expected to make in the future.

Comparable Company Analysis (CCA)

This method compares a company’s financial metrics, like revenue and earnings, to similar companies in the same industry.

There are various factors that affect the valuation of shares, such as:

• Financial performance: Aspects such as sales, earnings, cash flows, growth rate, profitability, etc., affect the valuation of shares.

Generally, higher financial performance leads to a higher valuation of shares.

• Risk and uncertainty: The risk and uncertainty of the company, such as its business risk, financial risk, market risk, etc.

Generally, higher risk and uncertainty lead to lower valuation of shares.

• Market conditions: Demand and supply of the shares, the investor sentiment, the economic environment, the industry trends, etc., affect the valuation of shares.

Generally, favourable market conditions lead to a higher valuation of shares.

• Future prospects: The future prospects of the company, such as its growth potential, competitive advantage, innovation, diversification, etc., affect the valuation of shares.

Generally, brighter future prospects lead to a higher valuation of shares.

These factors are often subjective and difficult to measure and may vary depending on the method of valuation used.

Conclusion

Valuation of shares is a crucial skill if you want to invest in the Indian stock market. It helps to evaluate the performance, risk, and potential of a company and compare it with other companies in the same industry.

However, valuation of shares is not an exact science but rather an art that requires judgment, analysis, and experience.

Thus, you must do a proper analysis and understand each method before using it.

______________________________________________________________________________________

Disclaimer: Investments in the securities market are subject to market risks; read all the related documents carefully before investing.