BUSINESS
The stock market plays an important role in the financial system. Millions of Indians invest in the stock market every year, hoping to earn good returns on their investments. However, investing in stocks can be tricky, as stock prices do not always reflect the true value or worth of a company.
Read on to understand the relationship between stock prices and company valuation in the Indian context.
What drives stock prices?
Stock prices are driven by the forces of supply and demand. When more investors want to buy a stock than sell it, the share price tends to rise. When more investors want to sell the stock than buy it, the share price falls. Stock prices can change rapidly based on news, investor sentiments, earnings reports, economic conditions, and other factors that impact the demand for a stock.
Many factors unrelated to the company's fundamentals and intrinsic value can cause its share price to fluctuate. For example, high inflation might cause investors to sell stocks, driving down prices across the market. Or an optimistic economic forecast could spur a surge of buying activity, lifting prices. These forces impact all stocks, regardless of the actual performance or valuation of the underlying companies.
Understanding company valuation
To determine the true worth or valuation of a company, analysts examine financial metrics like:
By studying the company's financial statements and operations, analysts gain insight into its overall financial health and growth prospects. A company's valuation reflects analysts' estimates of its ability to generate profits and free cash flow now and in the future. The intrinsic value of a stock is based on the company's expected future cash flows, discounted back to the present.
Differences between price and value
Often, a company's stock price differs from its intrinsic valuation. Shares may trade above or below what the company is really worth.
Reasons for mispricing include:
The gap between price and value presents an opportunity for savvy investors to buy underpriced stocks and sell or avoid overpriced ones. Value investors look for shares trading substantially below their intrinsic worth.
Examining company valuation metrics
Here are some key metrics to analyse when valuing Indian companies and their stocks:
Valuation methods
No single method provides a perfect measure of intrinsic value. Investors should use multiple approaches and require a margin of safety when investing in the share market.
Special cases - Growth and cyclical stocks
For high growth companies like technology stocks, traditional valuation metrics often appear stretched. Investors are paying for the company's future potential rather than just near-term profits. Growth stock investors rely more on revenue growth, user metrics, market share gains and long runway. Cyclical stocks like materials and industrials see valuations expand and contract based on economic cycles. Earnings correlate strongly to GDP growth. Ratios appear elevated at cycle peaks and depressed at troughs when profitability normalizes.
Valuing IPOs and unprofitable companies
Newly public companies lack long trading histories. Pre-IPO private valuations serve as reference points. Revenue growth and user traction take priority over earnings. Unprofitable firms must demonstrate a viable path to profitability.
The bubble debate
Critics often allege that India's share market is experiencing a valuation bubble. The counter arguments cite India's positive fundamentals like demographics, growing middle class, reforms, maturing companies and under-penetration of products and services. While pockets of overvaluation likely exist, broad generalisations may be premature given the diversity of Indian stocks and sectors.
Technical factors like liquidity, retail investor participation and momentum can distort prices over short-to-medium periods. Nevertheless, over the long run, fundamentals win out and rational valuations prevail. Patience and discipline are rewarded most often.
(This article is part of DMCL Consumer Connect Initiative, a paid publication programme. DMCL claims no editorial involvement and assumes no responsibility, liability or claims for any errors or omissions in the content of the article. The DMCL Editorial team is not responsible for this content.)
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