How to do the Relative Valuation of stocks?
How to do the relative valuation of stocks?
“A great company is not a great investment if you pay too much for the stock.“
– Benjamin Graham, father of value investing.
Valuation is one of the most important aspects of investing in stocks. You might be able to find a good company, but if you not evaluating its price correctly, then it might turn out to be a bad investment.
There are two basic ways to do the valuation of stocks:
Absolute valuation
Relative valuation
The absolute valuation tries to determine the intrinsic value of the company based on the estimated free cash flows discounted to their present value.
The discounted cash flow model (DCF) is the most common approach for the absolute valuation.
However, there are few limitations of using absolute valuation as you will require to make few assumptions and the results are only as good as inputs.
Nevertheless, this post is not focused on the absolute valuation and we’ll discuss more in another post where you will require to understand a lot of complex terms like future free cash flow projections, discount rate (weighted average cost of capital- WACC) etc to find the estimated present value.
In this post, we are going to discuss how to do the relative valuation of stocks.
Relative valuation of stocks is an alternative to the absolute valuation.
It’s an easier approach to determine whether a company is worth investing or not.
Relative valuation compares the company’s value to that of its competitors to find the company’s financial worth.
It’s similar to comparing the different houses in the same locality to find the worth of a house. Let’s say if most of the 3BHK apartment in a locality costs around 70 lakhs and you are able to find a similar 3 BHK apartment which costs 50 lakhs, then you can consider it cheap.
Here, you do not find the true worth of the apartment but just compare its price with the similar competitors.
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