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10. Valuation Principles

Difference between Price and Value

Mr. Seth Klarman, a known value investor stated “In capital markets, price is set by the most panicked seller; value, which is determined by cash flows and assets, is not.
Warren Buffett is also known to state frequently “Price is what you pay and Value is what you get.”

Why Valuations are required

Valuations are important because they help individuals and businesses determine the fair market value of a certain item or asset. This helps in making informed decisions when it comes to buying, selling, or transferring property. Valuations also provide a basis for taxation, insurance, and other legal matters. Valuations help ensure that the value of the property is accurately assessed and that the parties involved are treated fairly.

Sources of Value in a Business – Earnings and Assets

Warren Buffett stated, “There are only two sources of value in a business – Earnings and Assets”.

Earnings: Earnings refer to a companys net income, or the money left over after subtracting expenses from revenue. This figure is used to measure a companys profitability, and is typically derived from operations and investments.

Assets: Assets refer to physical and financial resources owned by a company that generates revenue or increase in value over time. These include tangible assets such as land, buildings, and inventory, as well as intangible assets such as patents, copyrights, and goodwill.

Approaches to valuation

Cost based valuation: Under this approach, an asset is valued based on the cost that needs to be incurred to create it. This option is suitable only for a buyer who has choice between buying versus making.

Cash flow based valuation (intrinsic valuation):- Intrinsic valuation approach assigns value to an asset based on what an investor would be willing to pay for the cash flow generated by the assets.

Selling price-based approach (relative valuation): Under this approach 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.

 

Discounted Cash Flows Model for Business Valuation

The discounted cash flows model for business valuation is a method of estimating the value of a business based on the present value of its future cash flows. The idea behind the model is to discount the future cash flows of the business back to the present, thus accounting for the time value of money and the risk associated with the estimated cash flows. The model is based on the concept of the time value of money, which states that a dollar today is worth more than a dollar in the future because of the potential to invest the money and earn a return. The discount rate used in the model is typically the weighted average cost of capital, which reflects the cost of borrowing and the risk associated with the cash flows. The model is commonly used to value businesses, as well as to evaluate potential investments.

    • Dividend discount model (DDM)– The dividend discount model (DDM) is a method of estimating the intrinsic value of a company’s stock based on the present value of its future dividend payments. The DDM assumes that the value of a share of stock is equal to the present value of all future dividends that the stock will pay out. To calculate the intrinsic value of a stock, the investor must estimate a future stream of dividends, discount this stream at a required rate of return, and then sum the present values of the individual dividends.
      The DDM is a popular valuation method for stocks that pay dividends, as it makes the assumption that dividends are the most important component of stock returns. The model takes into account the time value of money and the uncertainty of future dividend payments in order to estimate the intrinsic value of the stock.
      The DDM is often used to compare the current market price of a stock to its estimated intrinsic value. If the stock is trading below its estimated intrinsic value, then it may be considered undervalued, and thus an attractive investment opportunity. On the other hand, if the stock is trading above its estimated intrinsic value, then it may be considered overvalued and thus a less attractive investment opportunity.
    • Free cash flow to equity model (FCFE): The free cash flow to equity (FCFE) model is a method of valuation used to calculate the intrinsic value of a company’s stock. The FCFE model is based on the idea that the value of a share of stock is equal to the present value of all future cash flows that the stock will generate. To calculate the intrinsic value of a stock, the investor must estimate a future stream of cash flows, discount this stream at a required rate of return, and then sum the present values of the individual cash flows.
      The FCFE model is most useful for stocks that do not pay dividends, as it takes into account the cash flows that will be generated from operations and investing activities. The model is an effective way to estimate the intrinsic value of a stock, as it takes into account the time value of money and the uncertainty of future cash flows.
      The FCFE model is often used to compare the current market price of a stock to its estimated intrinsic value. If the stock is trading below its estimated intrinsic value, then it may be considered undervalued, and thus an attractive investment opportunity. On the other hand, if the stock is trading above its estimated intrinsic value, then it may be considered overvalued and thus a less attractive investment opportunity

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

Dividend Yield –

Price to Dividend Ratio: The dividend yield price to dividend ratio is a financial metric used to measure the amount of dividend income a company pays relative to its stock price. This ratio is calculated by dividing the dividend per share by the stock price per share. The dividend yield price to dividend ratio is used to compare the dividend yields of different stocks, as well as to compare a companys dividend yield to its industry peers.

Dividend Yield = Dividend Per Share (DPS) / Current Price of Stock

The Earnings Yield –Price-to-earnings

The earnings yield – price to earnings ratio is a financial metric used to measure the amount of earnings a company generates relative to its stock price. This ratio is calculated by dividing the earnings per share by the stock price per share. The earnings yield – price-to-earnings ratio is used to compare the earnings yields of different stocks, as well as to compare a company’s earnings yield to its industry peers.

Earning Yield = Earnings Per Share (EPS) / Current price of stock

Price to Earnings Ratio = Current price of stock/ Earnings Per Share (EPS)

Growth Adjusted Price to Earnings Ratio (PEG Ratio)

The PEG Ratio is a calculation used to measure a company‘s current stock price relative to its expected future earnings growth. It is calculated by dividing the Price to Earnings (P/E) ratio by the company‘s estimated earnings growth rate. The PEG Ratio is used to determine whether a stock is fairly valued, undervalued, or overvalued, based on its current price and expected future earnings growth. The higher the PEG Ratio, the more overvalued the stock is. A PEG Ratio of 1.0 or less is typically seen as a sign of a stock being undervalued.

Growth adjusted Price to Earnings Ratio = [Current Price of Stock / Earnings Per Share] / Growth rate

Enterprise Value to EBIT(DA) Ratio

The Enterprise Value to EBIT(DA) Ratio is a calculation used to measure a company‘s valuation relative to its operating income. It is calculated by dividing the company‘s Enterprise Value (EV) by its Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). The higher the ratio, the more expensive the company is relative to its operating income. A ratio of 10 or more is typically seen as a sign of a stock being overvalued.

Enterprise Value (EV) to Sales Ratio

The Enterprise Value (EV) to Sales Ratio is a calculation used to measure a company‘s valuation relative to its sales. It is calculated by dividing the company‘s Enterprise Value (EV) by its sales. The higher the ratio, the more expensive the company is relative to its sales. A ratio of 3 or more is typically seen as a sign of a stock being overvalued.

Assets based Valuation Matrices

Assets-based Valuation Matrices are calculations used to measure a company’s current value based on its assets. These calculations vary depending on the type of assets being evaluated, but generally include measures such as Price to Book Value, Price to Tangible Book Value, Price to Sales, Price to Cash Flow, and Price to Earnings. These calculations provide investors with an indication of whether a stock is fairly valued, undervalued, or overvalued based on its current asset values.

Price to Book Value Ratio

The Price to Book Value Ratio is a calculation used to measure a company‘s current stock price relative to its book value. It is calculated by dividing the company‘s stock price by its 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.

Price/Book ratio = Market capitalization / Balance sheet value of equity
(or)
Price/Book ratio = Price per share / Book value per share

Enterprise Value (EV) to Capital Employed Ratio

The Enterprise Value (EV) to Capital Employed Ratio is a calculation used to measure a company‘s valuation relative to its capital employed. It is calculated by dividing the company‘s Enterprise Value (EV) by its capital employed. 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.

EV to Capital Employed ratio = Enterprise Value / Capital Employed (Total Equity + Total Debt)

Net Asset Value Approach

The Net Asset Value Approach is a calculation used to measure a company‘s intrinsic value by subtracting its liabilities from its assets. It is calculated by subtracting the company‘s liabilities from its assets and dividing the result by the total 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

Relative valuation is basically intuitive. We do this all the time in our personal lives. Here, we try to value an asset by looking at how the market prices similar/comparable assets. The best example of this is pricing real estate. If you are looking to buy an apartment, you always find the price of
comparative apartments in that locality which kind of becomes your indicative value for negotiation purposes. This is a highly useful and quick estimate of value with limited computations and assumptions. However, it reflects a current market mood, which may be quite optimistic or pessimistic. Therefore, it is always good to use parameters like maximum, minimum, average, etc. while using relative valuations.

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. Without attempting to do this impossible task, let us state that in new age economy, people use absolutely new parameters/language such as eyeballs, page reviews, footfall, ARPU, no. of users etc.

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Chart Source– Tradingview.com

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