Determining the right value of a stock

The Indian stock markets are currently at their all-time highs and there is talk of valuations being stretched to an extent that these may not be sustainable going forward. On the other hand, some analysts opine that the encouraging earnings of some of the frontline companies would call for re-rating of the stocks and, therefore, the valuations are justified.

Now, there are three tools to determine whether the value of a stock is justified or otherwise. These are quite common insofar as analysts are concerned, but the uninitiated investor or an investor who is new to the markets would have no idea as to how to determine whether the stock is over-priced or under-priced. So, here we go:

Price-to-Earning (P/E) ratio: This is the most common and popular tool to gauge the valuation of a particular stock in relation to its earnings. So, if the P/E of a stock is 20, it means the price of the stock is 20 times that of it earning per share. The P/Es of the company’s peers and industry P/E is taken into account to adjudge whether the stock is under-priced or over-priced in relation to its peers and the overall industry.
Price-to-Book (P/B) ratio: The P/B ratio shows the market valuation (price) of the stock in relation to the book value of the company’s share. So, if the P/B is higher than one, it means that the stock is priced at a premium to its worth as reflected in the company’s books.

Price-to-Earning Growth (PEG) ratio:Popularised by the legendary investor Peter Lynch, this ratio presents an improvement on the P/E ratio. It takes into account the earning growth rate and is obtained by dividing the stock price with the growth rate. A PEG below one makes the stock attractive for investment.