Investment is all about market risk. Investing in stocks require a good analysis of the companies. Mere blindly putting all the money in any company may bring a loss. I incurred huge loss in my starting days, before learning some strategy about company valuation.
Valuation checks are crucial before investing in shares as they help determine a stock's true worth, allowing investors to identify undervalued opportunities and avoid overpaying for assets. It is a critical tool for investors to assess the potential of an investment, avoid costly mistakes, and ultimately achieve their financial goals. But how one should check the valuation?
Over the years, I have realised one simple trick to avoid overpaying for any company. The Starting Point of Valuation Check begins by simply compairing :
PE and RoE
It is always advisable to compare its PE with its RoE.
Here’s why:
– PE (Price to Earnings) tells you how much you’re paying
– RoE (Return on Equity) tells you how much company is earning on its own money
The basic rule that supports this valuation check is :
If RoE > PE → valuation is reasonable
If RoE < PE → stock may be expensive
Take an example to help understand this check.
– Company A: PE = 12, RoE = 18 → Reasonable
– Company B: PE = 24, RoE = 10 → Risky
This single check has saved me from several value traps. Because profit can be shown, but return on equity is harder to manipulate.
- Price to Earnings :
The Price-to-Earnings (P/E) ratio compares a company's stock price to its earnings per share (EPS), indicating how much investors are willing to pay for each rupee of the company's earnings. A higher P/E ratio generally suggests investors expect higher future earnings growth, while a lower P/E ratio may indicate the opposite or that the stock is undervalued.
- Return on Equity:
The Return on Equity , is a profitability ratio calculated by dividing a company's net income (profit after taxes) by its shareholders' equity, i.e the value of the company owned by its shareholders. A higher ROE generally suggests that a company is more efficient at using shareholder investments to generate profits, while a lower ROE might indicate less efficient use of funds.
In good faith - Peace!!
