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.
|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 company’s 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||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-
|Price to Book Value Ratio||Price/Book ratio = Market capitalization / Balance sheet value of equity
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.