VALUATION METRICS IN EQUITY SHARES

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Valuation Metrics

 

Hello viewers, we covered all the quantitative financial valuation metrics to value the stocks. Basically, valuation metrics are ratios and financial models that can give a fair idea about the company and investors find out the intrinsic value of the company.

Our readers familiar with the intrinsic value calculation and analyze the quantitative ratios to understand the growth of the company. We had started the advanced method of analyzing stocks in a simple way.

Just recollect our previous article, a discounted cash flow method analysis that is the most suitable stock valuation method for the analysts. It’s widely applicable in all areas of finance. Before dive into the DCF analysis, we need to understand some basic calculation, lets a have a discussion on it.

 

In DCF calculation, investors expect some amount of return that is called a discounted rate. For business, it is a weighted average cost of capital. Before going to the DCF analysis, investors should calculate the WACC.

CALCULATION OF VALUATION METRICS:

 

WACC = (E / V x Re) + [D / V x Rd x (1 – Tc)]

Readers have confusion in their mind, these are the financial terms, let us understand one by one

 

E => Market value of business equity

D => Market value of the business debt

Re => Cost of equity

V => Total market value of business (E+D)

Rd => Cost of debt

Tc = > Rate of corporate tax

Most of us have an idea about equity capital, debt, and the corporate tax system but we don’t know what is the cost of equity and cost of debt.

 

Let’s try to understand the term cost of equity and how to calculate,

           Re => RF + β * [E (Rm) – RF]

    Cost of equity = Risk-free rate of return + Beta × (market rate of return – the risk-free rate of return)

The risk-free rate of return means, the expected return from a risk-free investment like a 10-year government bond yield.

 

Beta:

 

The measure of systematic risk of the asset relative to the market. We had explained, how to calculate the beta by regression analysis. Kindly check the mutual fund risk ratio analysis article here

Some insights from the beta value

β< 1 => stock is less volatile than market

β>1 => stock is more volatile than the market

β = 1 => stock is tracking the market volatility

 

Let’s understand one more term, what the cost of debt is and how to calculate

 

                                Cost of debt => Interest expense * (1- tax rate)

 

For example, company XYZ Ltd has taken a loan from a bank of ten lakhs rupees for a business at a rate of interest of 7% and the tax rate is 20%. Now we can calculate the cost of debt

Assuming, the interest will calculate based on the simple interest method

Interest expense = Loan amount * Rate of interest

= 1000000 * 7%

= 70000

Cost of Debt => 70000 * (1-20%)

= 56000

The cost of debt will explain the financial condition of the company and also measure the risk level of the company. If the debt of the business is high, then risk will be high, before making investment decisions, investors should calculate the cost of debt.

Most investors wondering about, why should calculate the cost of debt, take some of the key insights from the calculation

 

KEY TAKEAWAYS – VALUATION METRICS:

 

  • Once the cost of debt is calculated then investors could evaluate the loan by comparing business income that the loan has generated over the period of time.
  • The interest expense is treated as a business expense in their balance sheet for tax saving purpose.

 

Finally, we come to the final stage of the WACC calculation. Let’s take one more example to simplify the calculation

Company XYZ has an equity capital of 40 lakhs and its long term debt was 15 lakhs for the fiscal year 2020. Therefore the total market value of the company is 55 lakhs.

V => E+ D (Equity capital + debt capital)

Assume that the cost of equity and cost of debt is 5.6% and 5.2% respectively. The rate of the corporate tax rate in India is 15%

By using the above formula

 

WACC = (E / V x Re) + [D / V x Rd x (1 – Tc)]

= (40/55* 5.6%) + [15/55* 5.2% * (1-15%)]

= 0.0407 + 0.0141

= 0.0526 or 5.26%

Shareholders of XYZ Company received a 5.26% average return every year.

 

CONCLUSION:

 

We have complete the basic calculation of the discounted cash flow analysis model also have an idea of how to calculate the weighted average cost of capital.

These are the new terms for beginners, don’t make complicate our aim is to calculate the expected rate of return from the future cash flow of the company.

Try to understand the terms and calculate the return on your investment.

                                                  HAPPY INVESTING!



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Fincareplan provides an advisory of financial, investment planning on equity shares, and mutual funds practically.
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