It’s easy to feel lost when trying to figure out what a company’s shares are really worth. Numbers, ratios, and market chatter can make it seem like everyone has a different answer.
You might have asked yourself why one calculation shows one value while another says something completely different. The real challenge is knowing which stock valuation methods actually give a clear picture.
In this blog, you will get a step-by-step understanding of stock valuation, starting with what stock valuation is and why it matters. We will explain the top 7 methods and common mistakes to avoid.
Let’s get started!
Quick Overview
Stock valuation methods help you understand a company’s true worth from different angles.
Absolute methods like DCF, Dividend Discount, and Residual Income focus on the company’s own financials.
Relative methods like P/E, P/B, P/S, and EV/EBITDA compare a company with its peers or industry averages.
Avoid common mistakes like unrealistic growth assumptions, ignoring debts, or relying on a single method.
What Stock Valuation is About?
Stock valuation is the process of assessing the worth of a company’s shares by analysing its financial statements, assets, earnings, and market conditions. It provides a systematic way to estimate a stock’s value using different stock valuation methods.
With the basics of stock valuation clear, it’s time to explore the key methods that help you put numbers to a company’s worth.
7 Best Stock Valuation Methods
When it comes to understanding stock valuation methods, several widely used approaches help determine the fair value of a company’s shares. Each method has its own focus and is suitable for different types of companies or financial situations. Here is a detailed look at the main methods:
1. Relative Valuation Methods
Relative valuation methods help you compare a stock’s value to other similar companies or industry benchmarks. These methods are useful if you want to see if a stock is over- or undervalued in the market.
Price-to-Earnings (P/E) Ratio
The P/E ratio shows you how the market price of one share compares to the company’s earnings per share. It basically tells you how much you are paying for ₹1 of earnings.
Best For: You can use this to compare companies in the same sector and see which ones are over- or undervalued.
Formula: P/E Ratio = Market Price per Share / Earnings per Share (EPS)
Example: If a share costs ₹200 and the EPS is ₹10:
P/E = 200 / 10 = 20
Pros: You can calculate it easily, and it is widely used for quick comparisons.
Cons: It doesn’t account for company growth, debt levels, or other financial factors.
Price-to-Book (P/B) Ratio
The P/B ratio helps you see how the stock price compares to the company’s net assets (book value) per share.
Best For: This is useful if you are looking at asset-heavy companies like banks or manufacturing firms.
Formula: P/B Ratio = Market Price per Share / Book Value per Share
Example: If the share price is ₹150 and the book value per share is ₹100:
P/B = 150 / 100 = 1.5
Pros: You can use it when tangible assets are important.
Cons: It does not consider intangible assets like brand value or intellectual property.
Price-to-Sales (P/S) Ratio
This ratio helps you understand how the stock price compares to revenue generated per share. It’s useful when profits are low or inconsistent.
Best For: You can use this for companies with strong sales but irregular earnings.
Formula: P/S Ratio = Market Price per Share / Sales per Share
Example: If the share price is ₹120 and sales per share are ₹40:
P/S = 120 / 40 = 3
Pros: Helps you when earnings are unstable.
Cons: Sales alone do not tell you whether the company is profitable.
Price-to-Cash Flow (P/CF) Ratio
This ratio shows you how the stock price compares to cash generated per share from operations. It focuses on actual cash rather than accounting profits.
Best For: You can use it for companies with strong cash flow but unpredictable earnings.
Formula: P/CF Ratio = Market Price per Share / Cash Flow per Share
Example: If the share price is ₹100 and the cash flow per share is ₹20:
P/CF = 100 / 20 = 5
Pros: It shows you the real cash the company generates.
Cons: It does not consider non-cash factors that may affect future cash flows.
2. Absolute Valuation Methods
Absolute valuation methods estimate the intrinsic value of a stock based entirely on the company’s own financials, without comparing it to other companies. You use these methods when you want to know what a stock is really worth on its own.
Dividend Discount Model (DDM)
The DDM helps you value a stock based on expected future dividends, discounted to their present value.
Best For: You can use it if the company pays regular, reliable dividends.
Formula: Stock Value = D1 / (r - g)
Where:
D1 = Dividend expected next year
r = Required rate of return
g = Dividend growth rate
Example: If the next year’s dividend is ₹5, the growth rate is 5%, and the required return is 10%:
Stock Value = 5 / (0.10 - 0.05) = ₹100
Pros: Shows you the cash returned to shareholders.
Cons: Not useful if the company does not pay dividends.
