Zerodha Varsity · Module 3 · Fundamental Analysis ← Prev: Ch 9–10 · Financial Ratios (Parts 1 & 2)
Chapters 11–12. Is the stock cheap or dear, and is the business worth owning at all? The valuation ratios, the idea of a moat, and a 10-point checklist to separate investment-grade from junk.
A wonderful company can be a terrible investment — if you overpay for it. All the profitability and efficiency in the world doesn't help if the market has already priced in a decade of good news. Valuation ratios answer the one question that decides whether a great business becomes a great investment: what are you paying for each rupee of what you get?
Valuation is the estimate of what something is worth — and it dictates the price you pay. Sometimes a mediocre business at a cheap price beats an exciting business at an absurd one. Valuation ratios compare the share price against an aspect of financial performance, and (like every ratio) they only make sense compared to peers. The source uses ARBL at its 28-Oct-2014 price of ₹661, with 17.081 Cr shares.
Price to Sales (P/S) compares price to sales per share. Sales per share = total revenue ÷ shares = 3482 ÷ 17.081 = ₹203.86, so P/S = 661 ÷ 203.86 = 3.24x. Useful when earnings are distorted (cyclical lows, big write-offs). Check: a higher-margin company's sales are worth more, so a higher P/S can be justified — if Company A keeps ₹250 PAT per ₹1000 sales and Company B keeps ₹150, A's sales deserve a richer multiple.
Price to Book Value (P/BV) compares price to the "salvage value" per share — what shareholders would get if the company liquidated. BV = (share capital + reserves − revaluation reserves) ÷ shares = (17.1 + 1345.6 − 0) ÷ 17.081 = ₹79.8. P/BV = 661 ÷ 79.8 = 8.3x. High = potentially overvalued vs book; low = potentially undervalued.
Price to Earnings (P/E) — the "financial ratio superstar" — is price ÷ EPS. EPS = PAT ÷ shares = 367 ÷ 17.081 = ₹21.49, so P/E = 661 ÷ 21.49 = 30.8x. It measures what the market will pay per rupee of profit: a P/E of 30.8 means participants pay ₹30.8 for each ₹1 ARBL earns.
P/E moves with price, not earnings. If ARBL jumps to ₹750 while EPS stays ₹21.49, P/E rises to 34.9x — the stock got "more expensive" though the company earned exactly the same. A rising P/E on flat earnings means rising expectations, not rising profits.
The P/E denominator is earnings, and earnings are the most manipulable line in the accounts. Watch for: frequent accounting-policy changes; under-provisioning depreciation to inflate profit; and — the biggest tell — earnings rising while cash flow and sales don't. If profit climbs but operating cash doesn't follow, be suspicious of the E in P/E. The author avoids stocks above 25–30x regardless of sector.
Reading the math once is not the same as owning it. Below is the same calculation as a live sheet: the ARBL numbers are pre-loaded, so you can confirm the book's P/E of 30.8× for yourself, then change the price to ₹750 and watch it climb to 34.9× on flat earnings — the trick above, made tangible. Switch to Apple to see the same five ratios describe a very different business.
↗ These tools also live in the Finance Lab — with more comparisons and a pattern-spotting drill.
Indices like the Nifty 50 have a P/E too — the combined market cap of all 50 stocks ÷ their combined earnings — and it gauges how cheap or dear the whole market is. In the source's 2014 reading: the Nifty peaked at 28x in early 2008 (before the crash), bottomed near 11x in late 2008–09, and historically ranged 16–20x (avg ~18x), with 2014 sitting near 22x — a level to be cautious at. NSE publishes this daily (updated ~6 PM).
Those "16–20x, cautious above 22x" thresholds are 2014-vintage and no longer describe the market well. Since then the Nifty has spent long stretches trading in the low-to-mid 20s and beyond — reflecting structural re-rating, lower interest rates for much of the 2010s, and shifting index composition. Use the method — check the current index P/E against its own recent history — rather than the fixed 22x line. Pull the live figure from the NSE site; don't anchor on a decade-old band.
In one breath: valuation ratios (P/S, P/BV, and especially P/E) tell you what you pay per rupee of sales, book, or profit — but P/E rides on price and its earnings denominator can be gamed, so treat a high multiple as a caution flag.
Everything so far — statements, ratios, valuation — was training for this: turning a company into a yes-or-no decision. First you need an idea worth investigating, then a way to test whether the business can defend its profits, and finally a checklist ruthless enough to reject a beautiful business the moment a red flag appears. This is where analysis becomes judgment.
Before the checklist, you need candidates. Six honest sources:
| Source | How it works |
|---|---|
| General observation | Watch what people buy (Peter Lynch's method) — PVR multiplexes spreading, Cummins gensets everywhere, naukri.com dominance. |
| Stock screener | Filter by parameters (RoE >25%, PAT margin >20%) — e.g. screener.in. |
| Macro trends | A national push (infrastructure) points to beneficiaries (cement). |
| Sectoral trends | A shift within a sector (energy drinks in beverages) surfaces adapters. |
| Special situation | A specific event (a respected director joining) triggers a look. |
| Circle of competence | Use your own profession — a doctor knows healthcare, a banker knows banks. |
Add anything interesting to a watch list and revisit it — a stock that fails the checklist today may pass it later as the business evolves.
Of the six, this is where a newcomer actually beats the professionals. An equity analyst covers 30 companies shallowly; you understand your own industry deeply. If you work in pharma, logistics, or software, you already know which players cut corners and which quietly dominate — knowledge no screener can give. Start your watch list in the industry you get paid to understand.
A moat (Warren Buffett's term) is a durable competitive advantage that protects a company's long-term profits from rivals. Analogy: a castle with a wide moat is hard to storm — a business with a strong, sustainable edge (brand, pricing power, market share) is hard to displace.
Examples: Eicher Motors' Royal Enfield — a niche brand priced between TVS and Harley, with fierce loyalty no rival can easily rattle. Infosys' moat was US–India labour arbitrage; Page Industries' was the Jockey manufacturing/distribution licence; TTK Prestige's was pressure cookers; Gruh Finance's was small-ticket lending to an under-served segment. True wealth creators almost always have a sustainable moat underneath.
Stage 1 — understand the business. Answer basic questions from the annual report and company site, not Google: What does it do? Who runs it? What does it make, where, at what capacity? Who are its clients, competitors, major shareholders? The author prefers businesses with little competition and light government intervention. If a red flag appears here, stop — don't proceed to stage 2.
Stage 2 tests whether the numbers match the story. Here's the author's starter checklist (build and refine your own over time):
| # | Variable | Target | Why |
|---|---|---|---|
| 1 | Gross Profit Margin | >20% | higher margin = evidence of a moat |
| 2 | Revenue growth | in line with profit | growth should track profit growth |
| 3 | EPS | consistent with PAT | diluting equity hurts shareholders |
| 4 | Debt level | not highly leveraged | finance cost eats earnings |
| 5 | Inventory | grows with PAT | check inventory days (mfg only) |
| 6 | Sales vs receivables | sales not propped by receivables | else it's just pushing credit sales |
| 7 | Cash flow from ops | positive | negative = operating stress |
| 8 | Return on Equity | >25% | but check debt alongside it |
| 9 | Business diversity | 1–2 lines | avoid sprawling conglomerates |
| 10 | Subsidiaries | not many | too many can mask siphoning |
Ignoring "sales backed by receivables." If revenue growth is matched by receivables growing just as fast, the company may be booking sales it hasn't been paid for — pushing product on credit to flatter the top line. Real growth shows up as cash, not as a ballooning receivables balance. (ARBL's receivables held steady around 13% of sales — a good sign.)
Stage 3 — valuation. Even a company that passes all ten points is a bad buy at the wrong price. The valuation exercise (the Discounted Cash Flow method, covered in the next chapters) estimates the intrinsic value so you know whether the market price is fair.
Don't treat it as "8 of 10, good enough." Its real power is the hard stop: a single serious red flag — negative operating cash, sales built on receivables, a maze of subsidiaries — should end the analysis no matter how good the rest looks. Great businesses are rare and you only need a few; the checklist's job is to help you say no quickly and cheaply, so you spend your ~15 hours only on the ones worth it.
In one breath: find ideas from what you know, insist on a durable moat, then run the three-stage due diligence — understand, checklist, value — treating any red flag as a reason to walk away.
A high P/E means the market is already paying a lot per rupee of earnings — expectations are high, so there's less room for upside and more room for disappointment. It also rides on price: the multiple can climb while profits stay flat. The author avoids stocks above 25–30x regardless of how good the business is, because the price already assumes success.
When earnings are unreliable — a cyclical company at the bottom of its cycle, or one with large write-offs that temporarily wipe out profit. Sales are harder to distort than earnings, so P/S gives a steadier read. Just remember to check the profit margin: higher-margin sales justify a higher P/S.
Durability means rivals can't easily copy or erode it over many years. Royal Enfield's brand loyalty, Page's Jockey licence, and Infosys's early labour-cost edge all kept competitors out for long stretches. A temporary lead (a hot product anyone can imitate) isn't a moat; a structural, hard-to-replicate advantage is.
Because each stage gates the next. If you don't understand the business (stage 1), the checklist numbers (stage 2) are meaningless, and valuing a business you don't understand (stage 3) is guessing. A red flag at any stage stops the process — there's no point valuing a company you'd never buy.
If receivables grow as fast as sales, the company may be booking revenue it hasn't collected — pushing product on generous credit to inflate the top line. That growth isn't real until it turns into cash. Healthy growth keeps receivables roughly stable as a percentage of sales, as ARBL's did around 13%.
No — it's a starting point you should adapt with experience. Different investors weight items differently (some obsess over governance, others over numbers). The discipline is that every item you keep must be backed by sound reasoning, and a serious red flag on any of them should stop you regardless of the rest.
Valuation decides whether a great business is a great investment — price vs value.
P/S = price/sales-per-share; P/BV = price/book-per-share; P/E = price/EPS.
P/E is the superstar but rides on price and its earnings can be manipulated.
Index P/E gauges the whole market — check it against its own recent history.
Stock ideas come from observation, screeners, macro/sector trends, events, and your competence.
A moat is a durable competitive advantage — invest where one exists.
Due diligence is sequential: understand → checklist → valuation.
Treat the 10-point checklist as a rejection tool; any red flag stops the analysis.
Shares = share capital ÷ FV. Then each ratio is price ÷ the matching per-share fundamental (sales, book, earnings).
Sona Ltd (Rs. Cr unless per share)
(a) Shares = share capital / FV = 20 / 2 = 10 Cr
(b) Sales/share = 4000 / 10 = 400
P/S = 300 / 400 = 0.75x
(c) Book value = (share cap + reserves) / shares
= (20 + 1180) / 10 = 120
P/BV = 300 / 120 = 2.5x
(d) EPS = PAT / shares = 400 / 10 = 40
P/E = 300 / 40 = 7.5x
Read: a P/E of 7.5x is low -> potentially cheap
(but always compare vs peers and check the E's quality).Why it matters: being able to build P/S, P/BV and P/E by hand means you can sanity-check any screener and see exactly what a "cheap" or "dear" label rests on.
Reasoning: each collides with a specific point — P/E rides on price, the checklist is a rejection tool, receivables-backed sales, and price is stage 3.
1) ERROR: rising P/E == rising earnings.
FIX: P/E moves with PRICE. Flat EPS + higher price -> higher
P/E. It signals higher expectations, not more profit.
2) ERROR: "9/10, so buy" — treating it as a score.
FIX: negative operating cash is a hard-stop red flag.
One serious fail ends the analysis, regardless of the rest.
3) ERROR: sales + receivables both up 40% = healthy.
FIX: sales backed by receivables = credit-pushed revenue,
not collected cash. Watch receivables as % of sales.
4) ERROR: great business => price doesn't matter.
FIX: valuation is stage 3. A wonderful company at an absurd
price is still a bad investment. Check the price.Why it matters: the final decision fails most often not on finding a good business, but on overpaying for it or ignoring one loud red flag.