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How does an analyst value a stock?

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By DK Aggarwal

Equity investment and trading has gained popularity due to its potential to deliver handsome returns. However, many investors have suffered losses or are unable to make the right bets, as they either pay too much for a stock and lose some of their capital or because they fail to spot the one that are available cheap, thereby letting go of the chance to make good money. This happens due to lack of knowledge about how to value a stock before making an investment.

When it comes to value stocks, fundamental analysis is the only way to spot the cheap ones. It is a method of valuing a stock by measuring its intrinsic value on the basis of related economic, financial and other qualitative and quantitative factors. From macroeconomic factors, such as the state of the economy and conditions of the industry, to microeconomic factors like the effectiveness of the company’s management and many others can affect the valuation of a stock.

Stock valuation may be of two kinds: absolute valuation and relative valuation. In the absolute valuation approach, analysts value a stock by discounting the company’s free cash flows by an appropriate discount rate and calculating the present value of the same. In relative valuation, they compare the value of the stock with those of its peers to assess whether it is worth investing. Relative valuation is great for quick evaluations and is an easy way to determine whether a company is worth more analysis. The metrics used for relative valuation comprise different ratios, like price to earnings, price to book value, price to earnings growth, price to free cash flow, price to sales, besides operating margin and enterprise value. Through relative valuation, a company’s value is compared with those of its competitors or industry peers to assess its financial worth.

Besides, the financial statement can help evaluate financial ratios that indicate the health or value of a company and its shares.

There’s more to analyzing a stock than just looking at valuation metrics. It is far more important to invest in a good business than a cheap stock. It’s important to understand a company’s business model when looking for good stocks. Focus should be on the strengths and weaknesses of the business. One needs to understand that there can be a strong company in a weak industry and a weak company in a strong industry. The strengths of a company are often reflected in things like unique brand identity, good products, strong customer base and wide distribution network, among others. So, understanding a company’s business model is of immense importance here.

Another area to look at is the management quality, which is a critical factor in stock valuation. It doesn’t matter how good a company’s product is, or how much growth is taking place in an industry if wrong people are making key decisions in the business. Key executives are responsible for the future of a company. During the earnings session, the market waits eagerly for management guidance. Simultaneously reading the annual reports of two or three companies can give a clearer picture on a business.

Besides, we should also focus on sectoral trends, and by doing that, an investor can determine which sectors to focus or which ones to avoid. Thus plenty of assumptions get built into using multiples for valuing a stock.

(DK Aggarwal is the CMD of SMC Investment and Advisors)

(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)

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