BlogNISM Series XV- Research Analy...10. Valuation Principles

10. Valuation Principles

Price and Value

Price refers to the amount of money that a buyer pays to a seller to purchase a product or service. It is determined by the market demand and supply, and can be influenced by various factors such as competition, availability, and marketing.

On the other hand, value refers to the perceived worth or usefulness of a product or service to the buyer. It is determined by factors such as quality, utility, and uniqueness. Value can be subjective and varies from person to person, whereas price is objective and uniform for all buyers.

Valuations are required to determine the fair market value of an item or asset. This helps individuals and businesses make informed decisions regarding buying, selling, or transferring property. Valuations provide a basis for taxation, insurance, and other legal matters, ensuring that parties involved are treated fairly.

According to Warren Buffett, there are two sources of value in a business – earnings and assets. Earnings refer to a company’s net income, which measures its profitability and is derived from operations and investments. Assets refer to physical and financial resources owned by a company that generate revenue or increase in value over time, including tangible assets such as land, buildings, and inventory, and intangible assets such as patents, copyrights, and goodwill.

Price Value
Set by the most panicked seller Determined by cash flows and assets
What you pay What you get
Subject to market fluctuations and emotions Based on objective evaluation of an asset

Approaches to valuation

Valuation Method Description Pros Cons Best Suited For
Cost-Based Valuation An asset is valued based on the cost that needs to be incurred to create it. Simple and easy to understand. Does not take into account the market demand for the asset. Buyers who have a choice between buying versus making.
Cash Flow Based Valuation (Intrinsic Valuation) An asset is valued based on what an investor would be willing to pay for the cash flow generated by the assets. Takes into account the cash flows generated by the asset. Requires accurate forecasting of cash flows. Investors who are interested in the income potential of the asset.
Selling Price-Based Approach (Relative Valuation) An asset is valued based on the price of other similar assets. Various valuation ratios such P/E, P/B, EV/EBITDA can be used as the valuation metric. Uses market-based information to determine the value of the asset. Does not take into account the unique characteristics of the asset. Assets that have comparable assets in the market.
Discounted Cash Flows Model for Business Valuation A method of estimating the value of a business based on the present value of its future cash flows. Takes into account the time value of money and the risk associated with the estimated cash flows. Requires accurate forecasting of cash flows and the discount rate. Businesses and investments that generate cash flows.
Dividend Discount Model (DDM) A method of estimating the intrinsic value of a company’s stock based on the present value of its future dividend payments. Takes into account the time value of money and the uncertainty of future dividend payments. Requires accurate forecasting of future dividend payments. Stocks that pay dividends.
Free Cash Flow to Equity Model (FCFE) A method of valuation used to calculate the intrinsic value of a company’s stock based on the future cash flows generated by the company. Takes into account the cash flows generated from operations and investing activities. Requires accurate forecasting of future cash flows. Stocks that do not pay dividends.

Relative valuation model

The relative valuation model is a method of estimating the intrinsic value of a companys stock by comparing it to similar stocks. The model uses the current market price of comparable stocks as a benchmark to estimate the value of the stock being analyzed. The relative valuation model works on the assumption that similar stocks should have similar values, and thus the market price of the comparable stocks can be used to estimate the value of the stock being analyzed. The relative valuation model is a useful tool for business valuation, as it is relatively simple to use and can be applied to many different types of stocks. The model is most useful when used in conjunction with other valuation methods, such as the dividend discount model, in order to get a more accurate picture of the value of the stock.

Earnings Based Valuation Matrices

Valuation Matrix Calculation Significance
Dividend Yield – Price to Dividend Ratio Dividend Yield = Dividend Per Share (DPS) / Current Price of Stock Measures the amount of dividend income a company pays relative to its stock price
Earnings Yield – Price-to-earnings Ratio Earning Yield = Earnings Per Share (EPS) / Current price of stock Measures the amount of earnings a company generates relative to its stock price
Price to Earnings Ratio Price to Earnings Ratio = Current price of stock / Earnings Per Share (EPS) Measures the price investors are willing to pay for each dollar of earnings
Growth Adjusted Price to Earnings Ratio (PEG Ratio) Growth adjusted Price to Earnings Ratio = [Current Price of Stock / Earnings Per Share] / Growth rate Measures a company's current stock price relative to its expected future earnings growth
Enterprise Value to EBIT(DA) Ratio Enterprise Value to EBIT(DA) Ratio = Enterprise Value (EV) / Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) Measures a company's valuation relative to its operating income
Enterprise Value (EV) to Sales Ratio Enterprise Value (EV) to Sales Ratio = Enterprise Value (EV) / Sales Measures a company's valuation relative to its sales

Assets-based Valuation Matrices-

Ratio Formula Interpretation
Price to Book Value Ratio Price/Book ratio = Market capitalization / Balance sheet value of equity
(or)
Price/Book ratio = Price per share / Book value per share
The higher the ratio, the more expensive the company is relative to its book value. A ratio of 3 or more is typically seen as a sign of a stock being overvalued.
Enterprise Value (EV) to Capital Employed Ratio EV to Capital Employed ratio = Enterprise Value / Capital Employed (Total Equity + Total Debt) The higher the ratio, the more expensive the company is relative to its capital employed. A ratio of 10 or more is typically seen as a sign of a stock being overvalued.
Net Asset Value Approach Net Asset Value per share = (Total assets - Total liabilities) / Number of outstanding shares The higher the ratio, the more undervalued the stock is. A ratio of 0.8 or lower is typically seen as a sign of a stock being undervalued.

Relative Valuations Trading and Transaction Multiples

Multiple Calculation Pros Cons Best used for
Price to Earnings (P/E) Market price per share / Earnings per share Easy to calculate, widely used Dependent on accounting policies and earnings quality Comparing similar companies
Enterprise Value to EBITDA (EV/EBITDA) Enterprise Value / EBITDA Compares the value of a company's operations to its debt and equity Can be skewed by differences in capital structure and depreciation policies Comparing companies with different capital structures and accounting policies
Price to Sales (P/S) Market price per share / Sales per share Easy to calculate, useful for companies with negative earnings Dependent on sales growth and profit margins Comparing companies in high-growth industries
Price to Book (P/B) Market price per share / Book value per share Useful for companies with tangible assets May not accurately reflect the value of intangible assets like brand value and intellectual property Comparing companies in asset-heavy industries
Enterprise Value to Gross Revenue (EV/Revenue) Enterprise Value / Gross Revenue Compares the value of a company's operations to its revenue Dependent on revenue growth and profit margins Comparing companies with high revenue and low profits

Sum of the Parts (SOTP) Valuation

Several businesses operate as a cluster/bundle of businesses rather than one business. For example, ITC, L&T, and other corporations have a different business under one umbrella. The best way to value these businesses is to value each business separately and then do the sum of those valuations. This method of valuing a company by parts and then adding them up is known as Sum-Of- Parts (SOP) valuation.

Other Valuation Parameters in New Age Economy and Businesses

Sometimes, people wonder on valuations of the new age businesses such as Ecommerce companies or tech companies such as Whatsapp, Zomato, Linkedin, Facebook, etc. Honestly speaking, it is difficult to put the numbers together to arrive at the valuations at which these transactions are happening. We may call it our own limitation to understand the value proposition.

  • Eyeballs: Refers to the number of views an online platform or website receives.
  • Page reviews: Refers to the number of reviews a webpage or product receives on a platform.
  • Footfall: Refers to the number of customers visiting a physical store or location.
  • ARPU: Stands for Average Revenue Per User, a metric used to determine the average revenue generated by each user or customer of a product or service.
  • Number of users: Refers to the total number of users or customers using a product or service.
  • Engagement metrics: Refers to the level of interaction or engagement that customers have with a product or service, such as the amount of time spent on a website or app.
  • Market share: Refers to the percentage of a market that a company or product has captured.
  • Network effects: Refers to the impact of a product or service on the value of other products or services within its network.

Mock-Test-

0 votes, 0 avg
0

Research Analyst

CHAPTER 10: VALUATION PRINCIPLES

1 / 61

1. How can an analyst identify if a company has a competitive advantage in product differentiation?

2 / 61

2. Which of the following taxes is a tool used by governments to encourage or discourage certain businesses?

3 / 61

3. How are weaknesses defined in SWOT analysis?

4 / 61

4. Why is it important for analysts to possess in-depth knowledge of the sectors while researching companies?

5 / 61

5. 3. What is the objective of good corporate governance standards?

6 / 61

6. What is pricing power?

7 / 61

7. 4. A good analyst must keep a track of disclosures, commitments, and deliveries of an organization periodically to adjudge a company. State whether True or False.

8 / 61

8. Why is it important for analysts to pay attention to the regulatory aspects of businesses?

9 / 61

9. What are examples of strengths in SWOT analysis?

10 / 61

10. 6. Which of the following is an example of migration across value chain?

11 / 61

11. 7. Which of the following is an example of migration across companies in the same industry?

12 / 61

12. Which of the following is not an example of a direct tax?

13 / 61

13. How are threats defined in SWOT analysis?

14 / 61

14. 5. Where can analysts find information on a company's corporate governance practices?

15 / 61

15. 4. According to SEBI's regulation on corporate governance, what is the minimum requirement for independent directors on the board?

16 / 61

16. What are the three areas in which a company can have a competitive advantage over its competitors?

17 / 61

17. Which of the following is included in the performance analysis of SCP analysis?

18 / 61

18. What are stars in BCG Analysis?

19 / 61

19. What determines the bargaining power of suppliers in an industry?

20 / 61

20. What are the factors that affect pricing power?

21 / 61

21. 1. Which of the following statements best describes the agency risk in a company?

22 / 61

22. In which scenario would suppliers have high bargaining power

23 / 61

23. 4. Which of the following sources of information is NOT commonly used by analysts to analyze companies?

24 / 61

24. What is the full form of BCG in BCG Matrix?

25 / 61

25. Why is it important for a business to know about political factors in a country where it is planning to do business?

26 / 61

26. Who can exert a lot of pressure and dictate prices, if there are a large number of sellers with similar products/services?

27 / 61

27. 1. If financials are great, it is expected that the quality of business is also goo State whether True or False.

28 / 61

28. What is the importance of studying a company's execution capabilities?

29 / 61

29. Conduct analysis of SCP analysis focuses on which of the following aspects?

30 / 61

30. What is the first step in the marketing research process?

31 / 61

31. What does SWOT stand for?

32 / 61

32. 3. Shareholding pattern and changes therein have to be informed by the companies to exchanges periodically. State whether True or False.

33 / 61

33. 1. What does the ESG framework in company analysis primarily focus on?

34 / 61

34. What are some examples of entry barriers for new entrants in a business?

35 / 61

35. According to the text, what should an analyst do if they cannot address what a company does with preciseness and clarity?

36 / 61

36. What are the key constraining factors in SCP analysis?

37 / 61

37. Which of the following is included in the structure analysis of SCP analysis?

38 / 61

38. 2. Corporate Governance takes into account which aspect of the Management?

39 / 61

39. What is the full form of STEEPLED?

40 / 61

40. What is the purpose of cess in India?

41 / 61

41. 2. Which of the following is NOT a criterion evaluated under the ESG framework?

42 / 61

42. An industry where rivalry is high, the end result will be pricing power and incomes for the industry participants.

43 / 61

43. Which of the following is considered as an economic factor in PESTLE analysis?

44 / 61

44. 3. What is one of the financial advantages cited for companies following the ESG framework?

45 / 61

45. According to the text, what is Dr. Garry Hamel's perspective on competition in the market place?

46 / 61

46. Why is it important to understand a company's business model before investing in it?

47 / 61

47. What are examples of opportunities in SWOT analysis?

48 / 61

48. 5. What is the importance of assessing the history of credit rating for equity investors?

49 / 61

49. What is the difference between a mission statement and a vision statement?

50 / 61

50. What is PESTLE Analysis?

51 / 61

51. What does Industry structure in Structure Conduct Performance (SCP) analysis refer to?

52 / 61

52. What is the role of company analysis in fundamental research?

53 / 61

53. The tyre industry in a country comprised of three organised players and several unorganised players. A sample survey revealed that around 20% of total sales came from unorganised sector. The three major companies reported revenue of Rs 6,000 crore, Rs 8,000 crore and Rs 10,000 crore, respectively, for the year 2019. Which of the following is closest to the fair estimate of overall size of tyre market in that country for the year 2019?

54 / 61

54. What is the reason for the introduction of the fat tax by the government of Kerala in 2017?

55 / 61

55. 2. When evaluating management competency, which of the following factors should be considered?

56 / 61

56. What are cash cows in BCG Analysis?

57 / 61

57. What is SWOT Analysis used for?

58 / 61

58. 10. What is the first step in the marketing research process?

59 / 61

59. What kind of industry is considered attractive from shareholders' perspective?

60 / 61

60. What is SCP Analysis?

61 / 61

61. Which of the following is not included in PESTLE Analysis?

Add a Comment

You must be logged in to post a comment