Deriving Business Valuation From Earnings

Investing in the stock market is not a game, it’s a process that requires skills to master and figure out the maximum outcomes in your favor.

Investing in the stock market is not a game, it's a process that requires skills to master and figure out the maximum outcomes in your favor. Click To Tweet

To get the maximum outcomes in your favor you need to understand and derive the business valuation.

For deriving business valuation, you need to understand the basics of equity first…

Basic Understanding of Equity

Equity is an equal ownership in a business, when you buy a stock you buy equities that means you buy an equal ownership in businesses.

Suppose you bought stocks of HDFC Bank, ITC, Reliance Industries, or any other company – you didn’t buy any piece of paper you just bought equal ownership in that company.

You can either buy equity directly by yourself or if you don’t want to do the hard work of selecting the right stock then you can also prefer the consistent performing diversified equity mutual fund.

How Valuation of Any Business Is Derived?

Let’s understand how price of any business is derived with an example.

Now, how will Mr. Amit derive the selling price or Valuation of his business?

So, Mr. Amit called all his friends and networks who might be interested in buying his photocopy business which is already earning Rs.5,00,000 annually.

There were 3 offers that Mr. Amit received for his photocopy business:-

1. Mr. Ravi offered Rs.10,00,000 (2 times of earning)
2. Mr. Sahil offered Rs.15,00,000 (3 times of earning)
3. Mr. Kartik offered Rs.5,00,000 (1 time of earning)

The Valuation of a Business is derived based on how many times of earnings a buyer is offering to buy the business.

If a buyer is offering 3 times of earning for above photocopy business, that is Rs.15,00,000 then the valuation of photocopy business is Rs.15,00,000.

This is how you can derive the business valuation based on earnings.

Understanding SENSEX & It’s Valuations

It is a barometer that represents the Indian Economy in stock markets all around the world.

Current Value of SENSEX is 35,171.27

Earnings of 30 Companies or Earning Per Share (EPS) is 1554.87

Times of Earning it is currently traded is (35,171.27/1554.87) = 22.62 times.

Currently, SENSEX valuation is 22.62 times of its earnings that are 1554.87 which results in the price or valuation of 35,171.27

Data as on June 26, 2020 | Source: bseindia.com

This is how valuation of SENSEX is derived based on earnings.

What Drives Growth In Equities?

Earnings! Yes, earnings are the only component that drives growth in equities.

In other words, the companies earning more profits will get its business valuations increased because where the profits increases demand also increases.

So, Growth In Earnings drives the Growth In Equities.

Long Term Returns from Equities =

Earnings/Profit Growth Rate + Dividends

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