As promised I am back with my new post on valuation. Before discussing anything about the topic, we need to understand the importance of 'Valuation'. Valuation is in the center of finance and has to be done for many different reasons like stock selection, initial public offering, venture capital investing etc. It is important to understand what we mean by value before starting our exciting journey of Valuation. I believe that value lies in the eyes of beholder. As a glass of water would worth a lot for a thirsty person and a lot less for a person who is not thirsty, the value of a security would depend on the expectations and assumptions of the appraiser. To confuse us more, the world of finance throws at us different kinds of value like market value, book value and intrinsic value. Market value is the price at which a security is traded at in the market. An important factor determining the market value of a security is the supply and demand in the market which in turn is affected by information available in the market. A recent example of how the price of a stock is affected by new information in the market is the 5% decrease in the share price of Apple just after the announcement of Steve Jobs's death (http://www.guardian.co.uk/technology/2011/oct/06/apple-stock-steve-jobs). The type of information affecting the price is determined by the efficiency of the market which could be the topic of a separate post. Moving forward, book value is the value at which a security is recorded in the balance sheet. There is no one way to define'intrinsic value' but it can be best defined as the value derived by an analyst by using the perfect valuation model and having all the information. In simple words it is treated as the true value of the security. The discussion of different types of value is by no means intended to confuse the readers but to provide a better and overall picture of the world of VALUATION.
We now know different concepts of value, but how can we actually value a stock? There are many methods available but the two most widely used are Discounted Cash Flow (DCF) method and the Relative Valuation method. DCF states that the value of an asset is the future cash flow generated by an asset discounted at its discount rate. In simple words, DCF suggests that if you own a stock, its value would depend on the future cash flow that it would generate in the form of dividends and the risk of your investment which would be reflected by the discount rate. It can be shown as:
There are many types of cash flow that is used like dividend, free cash flow to equity and free cash flow to firm. Similarly cost of equity or weighted average cost of capital (WACC) can be used as the discount rate. A point to note is that the cash flow and discount rate should be matched. Free cash flow to equity goes with cost of equity and free cash flow to firm is matched with WACC. To keep the introduction simple we would discuss cash flow and discount rate in details in some other post.
Relative valuation is comparatively simpler as it doesn't require many inputs and numerous assumptions. It values a stock based on how other similar stocks are valued in the market. It basically look for a comparable firm or a peer group, tries to find a price ratio like price to earnings, price to cash flow etc. and then applies that ratio to the target firm. To explain it further lets say that we need to value company A. We know the earnings of Company A is $2. Under Relative valuation method we would first find a peer group of company A having same risk-return characteristics. We would then find the price-earning (P/E) ratio of the peer group. Lets say that we find it to be 5. Now all we need to do is to apply this ratio to company A to find its value. As we know the earning of company A is $2, its price would be $2*5=$10 (earning*P/E). We do this because we believe that similar companies should be priced equally in the market.
This was an attempt to give an introduction to Valuation. The technicalities would be intensively explored in the coming posts. Please leave your insightful comments after reading the posts as it would provide me a feedback to improve my work. Also feel free to join this site and leave your email address if you want to receive the posts through email. Keep tuned, more to follow.........
We now know different concepts of value, but how can we actually value a stock? There are many methods available but the two most widely used are Discounted Cash Flow (DCF) method and the Relative Valuation method. DCF states that the value of an asset is the future cash flow generated by an asset discounted at its discount rate. In simple words, DCF suggests that if you own a stock, its value would depend on the future cash flow that it would generate in the form of dividends and the risk of your investment which would be reflected by the discount rate. It can be shown as:
Relative valuation is comparatively simpler as it doesn't require many inputs and numerous assumptions. It values a stock based on how other similar stocks are valued in the market. It basically look for a comparable firm or a peer group, tries to find a price ratio like price to earnings, price to cash flow etc. and then applies that ratio to the target firm. To explain it further lets say that we need to value company A. We know the earnings of Company A is $2. Under Relative valuation method we would first find a peer group of company A having same risk-return characteristics. We would then find the price-earning (P/E) ratio of the peer group. Lets say that we find it to be 5. Now all we need to do is to apply this ratio to company A to find its value. As we know the earning of company A is $2, its price would be $2*5=$10 (earning*P/E). We do this because we believe that similar companies should be priced equally in the market.
This was an attempt to give an introduction to Valuation. The technicalities would be intensively explored in the coming posts. Please leave your insightful comments after reading the posts as it would provide me a feedback to improve my work. Also feel free to join this site and leave your email address if you want to receive the posts through email. Keep tuned, more to follow.........
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