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Saturday, July 9, 2016

Relative Stock Valuation Methods for Investing

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StockInvestingTips Learning Series In continuation with previous post which explained the Absolute Stock Valuation Methods, read full post here(If you missed it). This post would explain the other way of stock valuation which is known as Relative Stock Valuation Methods. Relative methods for stock valuation consists of atleast 5 different ways for evaluating a stock. These all 5 methods would be explained one by one in this post.

Here are the 5 Relative Stock Valuation Methods:
1.P/E Ratio
2.Return on Equity
3.Operational Margin (OM)
4.Enterprise value (EV)
5.P/cash Flow ratio

Usage of Relative Stock Valuation Methods: Above mentioned 5 metrics should be used in combination while comparing two or more similar type of companies and choosing the best valued among them for investing your hard earned money. For example if an investor has shortlisted banking sector for investing and has to choose the best banking stock then he should compare different public banking companies and invest in the one which is more value for money proposition and is best of the lot under comparison.

These five constituents of relative stock market evaluation are rather easy to calculate. I'll take up each of them and explain way of calculating.

1. P/E Ratio:Price per earning ratio is simple to calculate for a company. P/E ratio is basically related to market capitalization of the company and Profit which the company makes. For eg - A company with market cap of a 3000 crore and profit of 300 crores have a P/E ratio of 10.

2. Return on Equity: Return on Equity is another relative stock valuation method which is widely used. There are multiple ways of calculating the ROE of a company.
First is rather simple where ROE is (Net income of company)/(shareholders’ equity).

Another method of calculating ROE if based on company's dividend growth rate and earnings retention rate.
Hence ROE = (Dividend Growth rate)/(Earnings Retention Rate).

3. Operational Margin : Operational Margin or operating margin is ratio of Operating Income and net sales.
Operational Margin = (Operating Income)/(Net Sales). This is straight forward and clear so I'll not further explain this method.

4. Enterprise Value: Calculating enterprise value is rather easy and straight forward as
Enterprise Value = Market Cap + Debt - Cash

5. Price/(Cash Flow) Ratio: Price to free cash flow is a valuation metric that compares a company's market price to its level of annual free cash flow. This is similar to the valuation measure of price-to-cash flow but uses the stricter measure of free cash flow, which reduces operating cash flow by capital expenditures. This is done as companies need to maintain or expand their asset bases (capital expenditure) to either continue growing or maintain the current levels of free cash flow.

Hence (Price to FCF) = (Market Capitalization)/(Free Cash Flow)

Hopefully now the readers are well aware of all the techniques for evaluating a stock before investing. Most of the professional Investors and analyst doesnot go beyond these valuation techniques, So it's high time to understand these all techniques of stock valuation and invest like a pro in future.

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