While dabbling around stock markets, do you often find yourself lost and surrounded by an ocean of terminologies? Were you confused when advised not to invest in an overvalued company? Have you wondered how companies arrive at their market value? Is there a difference between market capitalization and market value or between equity shareholding and shareholder funds?
Well, fear not, for the first step is for you to acknowledge what you don’t know. In this article, we will extensively cover basic terms like market value, how companies are valued, what ratios to consider, etc. so on and so forth. Intimidating that they sound, post this article, you can hold your head up high in any watercooler conversation around the stock market valuation! Let us jump in!
This article covers:
- What is market value?
- Market value vs. market capitalization
- How to qualitatively assess market value?
- Calculation of market value?
- How does it help in analysis?
- Limitations of market value
What is market value?
The term market value refers to a company’s or an asset’s worth in the financial market. A company’s market value is the price that investors are ready to pay for its shares.
In simpler terms, the market value of a company is influenced by how investors view its potential. The greater a company’s estimated worth, the greater is its market value.
Mathematically, market value can be arrived at using different methods, such as price/cash ratio, dividend yield ratio, P/E ratio, EPS, market value per share, book value per share, etc.
As an investor, you should know that market value fluctuates considerably with time. It depends on numerous factors like growth potential, supply and demand graph of a stock, choice of valuation methods, and whether a stock is reasonably priced or not.
Market value vs. market capitalization
Market value of a company is interchangeably used with market capitalization, but they are two separate concepts.
Market value is a reflection of a company’s financial position. It is a dynamic measure that depends on several fundamental and technical factors.
On the other hand, market capitalization can simply be estimated by multiplying the number of outstanding shares with the current share price. It is an exact measure of a company’s worth and is computed by the following formula:
Market cap = No. of outstanding shares X current share price
For example, in 1993, when Infosys was first listed on Indian markets, it opened to a price of Rs. 145, commanding a meagre market cap. But recently, it touched a market cap of Rs. 7.45 lakh cr., riding on its stock price hitting a record high of Rs. 1,755.
Nevertheless, markets remain filled with uncertainties. A company could be hit with bad results or face the entry of a new competitor. All of this impacts the perception of the company i.e, its market value. However, its market cap is technically dependent only on how its share fairs in the market.
How to qualitatively assess market value?
Analysts, traders, and investors use many mathematical tools, formulas, and ratios to determine a company’s market value. The most common are as follows:
The most common and simplest way of calculating a company’s worth is through the P/E ratio. Besides being the most important ratio, it simply tells the price that an investor is ready to pay for profits made per share.
In other words, this ratio is a measure of the earnings per share.
P/E ratio = Market price per share / Earnings per share (ESP)
(ESP = Profit after tax/ No. of outstanding shares)
P/E ratios are calculated for individual companies as well as industries on a whole. When a company’s P/E ratio is higher than its peers or the industry average, it can indicate that the company is fundamentally stable and performing well.
However, a high P/E ratio should not just be taken at face value. A company’s P/E ratio may be high due to short-term fluctuations or because it may have recently borrowed in huge quantities.
Whatever be the reason, the P/E ratio can make an investor overvalue a company and thus calls for detailed investigation into the numbers to ascertain if the ratio is inflated or otherwise.
A company can also have a low P/E ratio due to several reasons. It may have underperformed a quarter or is lesser in the news. A low share price naturally would result in a low P/E number. For this very reason, such companies can make good returns for investors as it remains potentially un-discovered, thereby undervalued by the markets.
More often than not, investors favour companies running on a low P/E ratio as these may be undervalued, giving a window to earn better returns.
This ratio is popularly used to assess the value of a company in terms of its debt, equity and earnings. EV/ EBITDA is also commonly referred to as Enterprise Value. It is extensively used when a company stands to be acquired. It is given by the formulae:
EV/EBITDA = Market value of equity + Market value of debt – cash / EBITDA
Note: EBITDA stands for Earnings before interest, taxes, depreciation, and amortization.
For example, if the value of this ratio stands at 3, it means that through just the EBITDA of the company, you shall recover your investment back in 3 years.
Again, a high EBITDA could indicate that the investor is paying more per profit unit, indicating that the company is overvalued.
For a better understanding of how valuations are perceived, have a look at this table.
EV for Oil and Gas companies (sample)
|S. no||Name of the company||Enterprise Value (in bn.)|
|1||Aemetis, Inc.||51.385 bn.|
|2||Reliance Industries ltd||16.866 bn.|
|3||Coal India ltd||79 bn.|
|4||Oil and Natural Gas Corporation||2,871 bn.|
EBITDA can also be used separately to arrive at market value. Often investors and other stakeholders arrive at a valuation by multiplying earnings with a multiple. For example, if a company’s earning an EBITDA of 20 cr. in a high growth industry, stakeholders might value it at 20 cr. multiplied by 10, i.e, 200 cr. The multiple depends on the company’s growth potential, the industry it is in, and general public sentiment.
Over EBITDA and P/E ratio, enterprise value is a preferred metric because it does not solely rely on equity or earnings.
But again, industries operate differently, thereby requiring unique valuation techniques. EV/EBITDA may not be a great choice for industries with high debt as their characteristic like in the case of the banking sector.
Another popular method to assess a company’s market value is by its Price/Book value. P/B ratio is typically what an investor is willing to pay per unit share of a company’s asset.
Price/book value = Market price per share / Book value per share
(Book value per share = Shareholder’s fund/no. of outstanding shares)
It is a metric widely used by banking and financial institutions as they run on high liquid assets.
Like any other financial ratio, the P/B ratio of a company may fluctuate or underperform for various reasons. For example, generally, Public sector banks have a much lower P/B than private banks. It thus becomes paramount to understand P/B or any ratio holistically than at face value.
It would interest you to note that industries have designed their own metrics to value companies. For example, multiplexes are valued at EV/Screens, whereas retail companies use Sales/sqft.
It, therefore, becomes clear that each industry uses its own metrics and standards to derive market values. But it is essential to note that using these metrics alone does not picture a company wholly. They should be considered along with all other fundamental and technical factors.
Calculation of market value
Market valuation can also be done by following methods:
Valuation by stock price
One of the easiest ways to evaluate market value is through stock price if it is traded on stock exchanges. For the companies whose financials are not available to the public, this method cannot be used to assess their market value.
For example, if a company XYZ Ltd. has 1 lakh outstanding shares, trading at Rs. 50, then the market value of this company would stand at 50 lakh.
Valuation by competitive analysis
Market valuation is also arrived at by looking at companies in the same sector on different parameters. Generally, this method is used for the companies whose shares are not traded in the market.
Suppose there are two companies, A and B, in the same industry, with similar profitability, and each has 50 cr. in annual sales. Now, if there is public information available that Company A is valued at 250 cr. In that case, stakeholders can reasonably conclude that Company B will also be roughly valued in the same range unless something significantly different.
How does valuation help in analysis?
The primary objective of evaluating market value is to accurately assess a company’s worth or value of a stock.
- Market value can be used to understand valuations broadly and technically.
- It helps to examine a company’s structure and profitability, thus, whether the stock is priced reasonably or underpriced.
- From the management’s point of view, the market value gives an idea of what investors think of its performance and growth prospects.
- It helps investors to figure out how the stock market is valuing the company.
- It brings transparency to buyers and sellers but shifts with time, depending on circumstances and determinants, like industry and economic conditions.
- Market value combines the ratios with stock trends in different economic circumstances for actual valuation.
Thus, combining different market value ratios can help investors make a better decision about an investment.
Limitations of market value
As explained, the market value is affected by various factors like what sector the company or asset belongs to, the financials etc. Thus, there are a few limitations of using market value to make investing decisions like the following:
- A company or share’s market value can fluctuate considerably as per the changing supply and demand graph. A rise in demand and steady supply can be a misleading factor of hiked market value.
- Determining the market value of a new company is hard because it requires precedent data. The company may also undergo a split or may increase its outstanding shares, technically impacting numbers.
It is important to understand the various methods used to value a company to extract maximum returns and have an edge in the markets. This requires both art and science because stock prices and their ratios might not always capture future potential and public sentiment. Hence, investors should have in-depth knowledge of different valuation methods to make informed investing decisions.
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