Stock Market is a Game of Valuation

Stock Market is a Game of Valuation

Please understand this very very important aspect. If a company is doing very well, sector is upbeat, growth is there but still the share price does not rise. You may have seen it happen many times. 

*Let's understand what is Valuation*

Suppose there is a factory producing some goods, making profits and has some land and the factory machinery. If you want to buy this factory, what price will you Pay? 

Obviously, it will be the sum total of future predictable profits for some 15 years, plus the land cost, plus depreciated factory cost plus some other aspects like brand value plus some other factors etc. Right ✅

Say valuation is 100 Cr, equity capital  is 10 Cr divided into 1 Cr shares of Rs 10/- each. So share price will be 100/- in the market.  Now suppose the company is making 5 Cr net profit per year, PE ratio will be 20, EPS being 5. This is a very classical case as an example. All parameters are in tolerance and everything looks Good. 

Now, look at *Coal India*

The PE of Coal India is 6. Why? Because, the valuer sees this company not sustaining at all in the longer period. The Coal sector is a Sunset Sector. Though, Coal India is trying to get into renewables, still it is miniscule. The current level of profits are not likely to sustain for 15-20 years at same levels. The fall in profits will be drastic after the tipping point which may come anytime in next few years. Mind you, this is a futuristic prediction/ assumption. Hence the current PE of 6 to this Company. If the profits of the company become half of current, PE becomes 12. 

Now look at *Zomato*

Net profit of Rs ~100 Cr per year. PE ratio is 125. But, it is a Sunrise sector. There is a behavioral shift happening in India with the Millennials who want to order from outside, sitting at home. They want 10 minute delivery. The business is growing at 30% yoy. Zomato is taking away market share of Kirana stores. Anyway, Zomato is doing too much on multiple fronts. But, the point here is that, the net profit of Zomato will zoom to 2000 Cr per annum from present 100 Cr per Annum. Then, what will be the PE. It will be 5 or 6, if the stock price remains same. 

So, it is not the PE ratio which is important. What is important is to assess the future of the Businesses and then invest in them. PE actually factors in the same aspects- Sentiment, business growth and number of other factors.... So don't just look at the PE and say that stock is expensive or cheap. Learn to assess the future of businesses. 

Asian Paints traded with a PE of 100 for 10+ years. Now it has come down to 50 due to disruption caused by entry of new players. 

Valuation is an Art,  like valuing a MF Hussain painting if you can predict the future with little accuracy also, you will do well as an investor. 

Enjoy the Weekend.