We know how to read the financial statements; now we must determine if the numbers on them are "cheap" or "expensive."
Chapter 7: Valuation – The Price is What You Pay, Value is What You Get
1. The Supermarket Analogy
Imagine you walk into a supermarket to buy toothpaste.
- Toothpaste A costs ₹100.
- Toothpaste B costs ₹500.
You immediately know B is "expensive." Why? Because you have an internal anchor of what toothpaste is worth.
In the stock market, the "Price" (displayed on Equiscale's terminal) tells you nothing in isolation. A stock at ₹2,000 can be "cheaper" than a stock at ₹50.
To judge value, we need Valuation Ratios.
2. The P/E Ratio (Price-to-Earnings)
This is the most common metric in the world.
$$P/E = \frac{\text{Market Price per Share}}{\text{Earnings Per Share (EPS)}}$$
- The Meaning: It tells you how much you are paying for ₹1 of earnings.
- The Indian Context:
- Nifty 50 Average P/E: Historically ~20x.
- Undervalued: If the market P/E drops below 15x (e.g., during Covid crash), it’s a sale.
- Overvalued: If the market P/E crosses 25x, it’s a bubble.
- The Trap: A low P/E isn't always good. Sometimes a company is cheap because it is dying (Value Trap). Always ask: Why is this cheap?
3. The P/B Ratio (Price-to-Book)
Used primarily for Banks and NBFCs (like HDFC Bank, Bajaj Finance).
$$P/B = \frac{\text{Market Price}}{\text{Book Value (Net Worth)}}$$
- The Logic: For a factory, book value (machinery) depreciates. For a bank, book value (money) is the raw material.
- The Benchmark: In India, a high-quality private bank usually trades at 3x - 4x Book Value. A PSU bank might trade at 0.5x - 1x.
4. PEG Ratio (Price/Earnings-to-Growth)
Developed to fix the flaws of the P/E ratio.
If a company is growing at 50% per year, it deserves a high P/E.
$$PEG = \frac{P/E \text{ Ratio}}{\text{Annual Growth Rate}}$$
- Peter Lynch’s Rule:
- PEG < 1: Undervalued (Buy).
- PEG = 1: Fairly Valued.
- PEG > 2: Expensive.
In high-growth India, finding stocks with PEG < 1 is the "Holy Grail."
5. Intrinsic Value & Margin of Safety
Benjamin Graham, the father of value investing, taught us that every stock has an Intrinsic Value (True Worth).
If the Intrinsic Value is ₹100, you should not buy it at ₹100. You should buy it at ₹70.
The ₹30 difference is your Margin of Safety.
It is your cushion against being wrong. If you buy at a discount, even if the company performs strictly "okay," you won't lose money.
Summary
Valuation is the difference between a great company and a great investment.
Infosys is a great company. But buying Infosys at a P/E of 100x would be a terrible investment.
Your job as an analyst is not just to find good businesses, but to wait patiently until the market offers them at a "mismatch" price.
Class assignment:
Log in to Equiscale's screener.
- Filter for companies with a P/E Ratio below 15.
- Add a second filter: Profit Growth > 20%.
- This list (Low P/E + High Growth) is your hunting ground for potential "PEG < 1" multi-baggers.