Just a while ago, I remember buying Onion at Rs.100/kg! Well, do you really think it was worth paying that hefty sum for a Kg of onion? No, right? Talk to some Agri-commodity traders, and you’ll hear that onion was “over-valued”! Coz, you know the market is in a swing triggered by demand and supply, and the market value has little to do with the true value. Eh, gotcha?
Likewise, in the stock market, the Valuation of shares is a word of every mouth. Well, if you aren’t aware, hold on till the end, and you’ll know as I explain in simpler layman’s terms…
Before diving into Valuation, here’s a simple intro to what shares are. Think… you and your group of friends order a pizza from Dominos. Each one of you gets to grab a slice, though not equal, probably on the basis of what you agree to pay. Now, if a company’s assets are in the form of a pizza, each shareholder gets a sector based on what he pays, i.e., the share price. Now, you would be wise enough to evaluate whether you got your deserving slice of pizza in line with your contribution, and well, that’s the process of Valuation.
What is the Valuation of Shares?
Valuation, as the term speaks for itself, is the process of valuing a company’s shares or assessing the true worth of a company’s business. A company’s market price (price at which it trades in the stock markets) may not necessarily be its true value.
For example – if X Ltd. trades at Rs. 450 in the stock markets, it only means that traders are willing to buy/sell at this price, and it does not necessarily mean that it’s worth that much. The true value could be more or less due to various reasons like management of the business, future prospective earnings, capital structure, etc.
Until now, what you read as ‘true value’, yup, that one, that’s what analysts love to call – ‘the intrinsic value’. So, basically, Valuation helps you fight the battle between intrinsic value (I.V.) and market value (M.V.); wherein if I.V. is less than M.V., it’s over-valued, and if I.V. is more than M.V., it’s under-valued. And need not to mention, if a commodity is under-priced, any rational person would generally recommend you buy it. By the way, Valuation derives its root from the premise that sooner or later, before you know, the market price will fall in line with the intrinsic value.
Why is the Valuation of shares necessary?
Now that you know what Valuation is, here’s why you’ll find it a lot in financial news –
Buying decision: whenever you’re buying a share or one company is acquiring another company, the Valuation of the selling company will be an important deciding factor because you would, obviously, not be willing to pay more than what you’re getting.
Selling decision: the selling company has a lot to do before a merger and acquisition deal is structured. You’ll need to entice the buyer to proceed with the deal and for that, you’ll need to come up with a valuation that is truly deserving. Keeping valuation information updated allows a company to grab opportunities as and when they come.
Funding: when you approach your bank for a loan with your company’s shares as collateral (security), they’ll ask you a valuation of those shares, failing which, you’ll have to let go of the funds. Thus, keeping valuation information handy will help you convey your credibility to lenders and other prospective investors.
Strategic planning: Valuation of shares requires information on various financial aspects of the business, which in turn helps you make proper business decisions.
Legal usage: whenever there is a dispute in the court over a business, information with regards to Valuation helps in making the ‘what’s whose’ dispute settlement smoother. You see... the more frequently you’re dragged to the court, the more are your litigation expenses and the more your attention is diverted from your usual course of business. Hence, to save on your time and money, have your Valuation ready for any unforeseen contingencies.
Other usages: Valuation of shares is also required for other purposes that, directly or indirectly, involve shares like - ESOP plans, conversion from preference to equity, etc.
How is the Valuation of shares done?
Now that you know what Valuation is and why it’s important let’s dive into the real crust of how Valuation is done.
FYI, here’s an overview of the main categorization of valuation methods:
- Absolute Valuation
- Relative Valuation
Well, let’s explore the Valuation in each category.
Absolute Valuation involves assessing the intrinsic value of a company based on its fundamentals, like - dividends, growth rate, cash flow, etc. So, you’re on your own here; there is no comparison with any other company. Needless to say, it’s backed upon fundamental analysis. Here are various methods of absolute Valuation:
This approach involves determining the value of each share-based upon the assets they deserve proportionately. In simpler terms, you arrive at the net assets of a business and find out what fraction of these assets is a single share entitled to. This approach is useful for capital-intensive business organizations like manufacturers that run heavily on fixed assets. Deduct all external liabilities from assets and divide it by the number of equity shares, simple.
Dividend Discount Model (DDM) vs Residual Income Model
DDM is based upon the premise that you arrive at the true value of a company when you discount back to the present date all the future dividend payments by the company and sum them all up. A variation of DDM is the Residual Income model, which takes the projected residual income in place of expected dividends. This is a viable option for companies not paying dividends.
Discounted Cash Flow (DCF) Model
As the name suggests, Discounted Cash Flow model discounts back all the future projected cash flows of a company and sums them all to arrive at its true value. Ergo, it is entirely based on the projection of how much cash a company can generate in the future.
*If you aren’t aware, I know you might find it difficult to understand discounting. Well, it’s not the ‘rebate-wala-discount’; rather, it’s the opposite of compounding. For e.g.: - Rs. 100 today at 10% interest would be Rs. 110 next year – compounding, whereas Rs. 110 next year will be worth Rs. 100 today – discounting. It’s all the magic of time, the value of money, cheers :)
Unlike absolute Valuation, relative Valuation involves the one Indian parents do once exam results are out. On a serious note, it involves comparing your company with the peers. And it’s implied that the measures used are ratios and multiples. Following are various methods of relative Valuation:
Price-to-earnings Ratio (P.E. ratio)
It’s one of the most widely accepted metrics for relative Valuation, which depicts how many times of the earnings we need to buy a share of the company. In simpler terms, if P.E. is 23x (23 times), we’re paying Rs. 23 to buy a share of a company that generates earnings of Rs. 1. Thus, it’s calculated by dividing the market price of a share by its earning per share. If two companies have everything else the same, the company which has a lower P.E. multiple will be considered as undervalued, and hence, a better buy opportunity than the other.
Company Comparable Analysis uses relative metrics like Enterprise Value to Sales ratio, Price to Earnings ratio, Price to Book value ratio, etc., to compare peers. Trading Comps is used to compare two companies similar in terms of their sector, operation or market capitalization. Whereas Transaction Comps is used to compare the transaction in question with similar transactions by alike companies in the remote past.
The bottom line
Hope you’ve got a simplified basic idea about Valuation. At the outset, you might be prompted to think that valuation stuff is all simple and sorted. But you need to take it with a pinch of salt; there’s a lot more than you can imagine. Hey, you know what’s doable? It’s the excel part, the computation, but the real intellect is deciding what you need to feed into the computer- the projections, the growth rate, the discount rate, the comparison, etc. No intention to discourage you but don’t overestimate your potential. If you aren’t competent enough, consult an expert. Don’t part with your hard-earned money without proper deliberation.
Valuation is an ocean where we’re all mere fishes; there is only one large shark, ‘the Dean of Valuation’ Mr. Aswath Damodaran. And I leave it to you with one of his quotes –
“Success in investing comes not from being right but from being wrong less often than everyone else.”
Take care, see ya:)