Meaningful Minutes

What is ‘valuation’?

Let’s suppose you go buy a smartphone. The seller offers you two options—one costing Rs 10,000 and the other Rs 30,000. Now on the face of it, the second smartphone seems more valuable, and thus, a better product. However, you then look at the labels and compare the features. The first one comes with 10 of the latest features; the second just about 12. This information, however, tips the scale. Now, it would seem like the phone with a lower price tag of Rs 10,000 seems more ‘worthy’ and ‘valuable’. When you buy stocks, you make a similar comparison. This perceived value of the stock is called valuation.

Why valuation is important for every investor:

Every stock is priced differently. And by simply looking at the price of a particular, it would be hard to understand which one is cheap and which is costly. For example, a stock costing Rs 500 may be costlier than a stock worth Rs 300 apiece. This is where valuation helps bridge the playing field. It essentially helps you compare apples to oranges.

How is valuation measured?

Usually, analysts compare the stock’s price with the company’s profits. You first calculate how many profits the company earns on a per-share basis. This is called the Price-to-Earnings or PE ratio. It helps you understand how many rupees you are paying for every rupee of profit earned. The more you have to pay, the costlier is the stock. Other measures are the Price-to-Book Value (PB or PBV), Price-to-Sales and Price-to-Ebitda.

The Earnings Yield valuation:

Those were the common valuation measures. Here’s a relatively unknown thumb rule—the relative valuation of debt and equity. Take the current PE of the Sensex. Now, inverse this amount and multiply by 100. The number you get is the earnings yield of the Sensex. If the earnings yield of the Sensex/Nifty is higher than the current yield of a 10-year government bond, then you can safely say that markets are relatively undervalued and vice-versa.

What’s the current earnings yield?

Currently, the 10-year government bond yields are at 6.45%. So an inverse of the current Sensex PE multiple of 22x is 4.5%. The difference between the two yields is quite large. This shows that markets seem overvalued currently.

What to make of the current level?

Remember, stock prices today reflect tomorrow’s profits. So, it’s important to compare with the Nifty’s forward PE—using expected profits, not past ones. The Nifty’s forward PE multiple is around 18x (earnings yield of 5.5%), according to a Livemint report. Even by this account, it may seem like the market may be overpriced. This is why many analysts are warning investors to be cautious when investing in the current market.