A valuation can be defined as the process of estimating the fair market value or the intrinsic value of a company. After analysing the market value (the price at which a stock can be readily bought or sold in the current market place) and the intrinsic value (actual value of the stock based on its perceived true value), one can decide whether to buy, sell or hold a company’s stock. If for a company:
- The market value is greater than the intrinsic value, one should sell
- The intrinsic value is greater than the market value, one should buy
It must be noted that all valuations, regardless of the method in use, have certain principles:
- Valuation is time specific. The value of a business changes everyday and depends on various factors such as the cash flow, earnings, working capital which are always in a state of flux
- Value depends on future cash flows. These are primarily done by calculating the present value of these future cash flows
- Certain market forces dictate the rate of return which is used to calculate the present value. These include the types of purchasers and general economic conditions
- Liquidity affects the value of a company. With the increase in the liquidity of a company, its value increases as well since these liquid assets act as a security for the stockholders in case of a bankruptcy
- Value is affected by underlying assets. This is primarily because with the increase in net assets, the likelihood of a company defaulting decreases since the liquidity is higher
Types of valuations
- Relative Valuations Models
Such models do not estimate the exact value of the stock but instead compare a particular company with other companies or a benchmark with the help of ratios like the Price-Earnings Ratio (P/E).
- Absolute Valuation Models
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- Discounted Cash Flow Models
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Free Cash Flow = Cash Flow from Operations-(Total Capital Expenditure-After Tax proceeds from sale of assets)
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- Discounted Dividend Models
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Value of Stock = Dividend per Share / (Discount Rate – Dividend Growth Rate)
However this model can’t be applied for firms that don’t pay out dividends.
- Capital Asset Pricing Model
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Re = Rf + Ba*(Rm-Rf)
Where:
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Rf: This signifies the Risk-free Rate (minimum return that an investor expects) and can be calculated by observing government or treasury bonds.
Ba: This signifies Beta of the security which is a measure of the stock’s volatility and is reflected by measuring the fluctuation of its price changes relative to that of the market.
Rm-Rf: This signifies the risk premium that an investor should get for taking an additional risk due to the volatile nature of the investment.
फोजोबनाय
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Moreover, the valuation only aims to estimate the value of the stock of a company and hence one can tweak these models or use more than one model to get an insight into the company and reach that estimated value.
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