How to value a company?

Valuation of a Company

Valuation is the assessment of a company before buying into the stock. Every stock has a price tag on it. So at what price is a stock considered cheap?

Valuation of stock is not an exact science but it is the combination of art and science. So many valuation methods are available which will be used on the type of company. Here we discuss the valuation methods for determining growth companies.

•    Price to Earnings to Growth rate ratio ( PEG Ratio)
•    Discounted Earning Model

Price to Earnings to Growth Ratio (PEG)

PEG is an important criterion for valuation for growth companies. The ratio was introduced by Peter lynch. The PEG ratio can be calculated by:

 

PEG ratio = PE Ratio / CAGR (Compound Annual Growth Rate)

For example company, A has a PE ratio of 25 with a growth rate of 15%. It will have a PEG of 1.6= (25/15). Company B on the other hand has a PE ratio of 35 and a growth rate of 50%. It will have a PEG ratio of 0.7= (35/50). In this case company B is considered a better bargain even though it has a PE ratio of 35. Using the PEG ratio where a company’s growth rate is taken into consideration, it shows that Company B has more room to grow. 

In terms of margin of safety, when PEG ratio is 1, the valuation of a stock is considered fair value. But when it is half of the growth rate it is considered undervalued. This means that you are paying a discount to its future growth. If it is more than 1 we assume that it is overvalued because the PEG is 2. This is one of the best tools for calculating growth companies to judge whether a stock is valued at its bargain price.

Limitations of PEG ratio

It can only be used to gauge small companies. When it comes to mature companies with low growth, PEG ratio will become ineffective as it would appear to be overvalued when calculated.

It can only be used on companies that have consistent growth in their earnings per share. You will not be able to use the PEG ratio for companies with a cyclical nature.

As a general rule, the best time to acquire an outstanding business is when the PEG ratio is less than 0.5. In short the lower the PEG the cheaper the stock.

Determine the rate of growth – Compounded Annual Growth Rate (CAGR)

Compounded Annual Growth Rate is an average growth rate over a period of several years.

CAGR = (FV/PV)^1/n – 1

Where
FV= Future Value (Final year EPS or Revenue)
PV = Present Value (First year EPS or Revenue)
n = number of years.

2005-6 = 1 2006-7 = 2 2007-8 = 3 2008-9 = 4 n = 4

CAGR = (0.10/0.02)1/4 - 1 = (5)0.25 -1 = 1.4953 -1 = 0.4953*100 = 49.53%

We can assume growth companies as one that grows at more than 15% compounded consistently. Anything less than that is considered a non-growth company

Intrinsic Value

It is defined as the total amount of cash that can be taken out of a company in its lifetime, discounted at present worth at an appropriate interest rate. It can be calculated using different valuation approaches such as the

•      Discounted earning model,
•      Discounted cash flow model
•      Discounted dividend Model

The discounted cash flow model is used for blue chip or mature companies. These companies are more stable they have a strong generation of free cash flow every year.

Growth companies require more capital to be injected back into the business to grow and expand further they tend to have higher capital expenditure. And this will affect the volume of free cash flow during the initial stage. Discounted Earning model will be useful for the calculating the intrinsic value of growth companies. 

Disclaimer: This blog is exclusively for educational purposes and does not provide any advice/tips on Investment or recommend buying and selling any stock