The above quote from Benjamin Graham, father of Value investing shows the importance of valuing a stock.

Finding a good stock is not as difficult, companies with good and consistent growth, profitability, with relatively little or no debt and good capital efficiency are considered good. What matter the most is how much you are paying against its growth. The question is answered by valuing the company against its earnings.

In simple terms, valuation is comparing the present and future earnings of a company against price an investor is paying for it. If the price paid by the investor is lower than its future growth potential, then we assume the stock to be undervalued.

There are many popular valuation ratios, such as Price to Earnings(P/E), Price to Book(P/B), EV/EBITDA and many others.

While P/E measures the price of a the stock against its earnings, P/B measures the price of the stocks against the assets. EV/EBITDA(aka “Enterprise Multiple”) is a ratio that measure the theoretical take over value of a business, against the earnings of that business.

All these valuation ratios are quite popular and are frequently referred to by many market experts to understand the value of a company.

Despite their popularity, all these ratios are not flawless and do not give you a complete picture. P/E ratio measure the price of the stock against its earnings, it does not tell you anything about company’s current valuation against its future earnings potential.

A company with attractive P/E valuation, but little or no growth is not a great investment compared to a company with similar P/E but good growth record.

Example: NMDC, a largecap Public Sector mining company is trading at a P/E of 9.34 as on 25/06/2018,one of the lowest among peers, which means company is trading at attractive valuations. However, if we look at the earnings of the company, NMDC’s earnings have seen a consistent decline for the past 5 years from Net Profit of Rs. 6,342 crores in 2013 to Rs. 2,589 crores in 2017. Clearly, despite attractive valuation, NMDC is not a great investment.

Price to Book value is a measure to understand how cheap or expensive a company is compared to its assets. A company trading below its book value (that is P/BV <1) is an undervalued company. However, P/BV does not take into account the total assets of the company, so if a company is continuously selling may trade at a P/BV below 1, but that does not make it an attractive investment.   

Example: JP associates, a leading construction and engineering company is trading at an attractive P/BV of 1.1, making it an attractive investment, but if you look at the past history of the company, JP Associates’ assets have seen a decline from Rs. 95,482 crores in 2013, to Rs. 65.893 crores in 2017. Despite attractive P/Bv valuation JP Associates is not a good investment as its selling its assets to service its debt obligations.

EV/EBITDA is valuation ratio that has recently started gaining popularity due to the fact that it takes into account the theoretical takeover value of the company and measures it against the earnings of the company. However, it too has a flaw that is less obvious, which lies in the way EV is calculated.

The Enterprise Value of the company is calculated by taking the market capitalization of the company and adding all the debts of the business and subtracting the cash, as a company willing to buy the business would get all the cash company has, and has to pay all the debt obligations.

First, Market Capitalization is not an efficient measure to value a business, as market itself is inefficient.

Second, a company with lot of debt and very little cash will have low EV/EBITDA ratio, but such a business will not be able to survive for long time.     

Clearly, EV/ EBITDA despite its sophistication, is not an efficient valuation metric.

“Price is what you pay, value is what you get”. It is important to value a business before investing. Valuation gives you clear understanding of how much you are paying against the earnings and growth potential of the company. However, depending on a single valuation metric may give you incorrect result leading to losses. Thus, it is always important analyze the company’s earnings history it’s growth potential and riskiness to get a complete picture, which will help you understand the price and the value of the business and what you can expect from your investment in the future.