The Valuation Game | Trade Samaritan

The Valuation Game

The most interesting part about calculating ‘value’ in financial economy is that the ‘value’ here is always ‘relative’; it means different to different people.

“To a dog a bone has more value than a pearl.”

In simple terms – value is the worth or the usefulness of something. Trading and Financial markets are based on values of underlying instrument, be it bonds, stocks, commodities or currencies. The prices, buying, selling, hedging and speculation, all of it runs on the ‘perceived value’ of the underlying instrument or the commodity. Consumers and investors sentiments and perceptions about the value play a very big role in the markets. ‘Value’ in trade and financial markets is always used as a relative term. Competitors will value the firm differently as compared to the firm which is interested in acquiring it.

Let’s take a look at commonly used value terms. 

It is very interesting to learn that the same firm can be valued on different parameters fetching distinct valuations.

1.       Book value: Book value is the value of the asset as quoted on the balance sheet. It denotes the value of the asset the shareholders will get if the company is liquidated. To derive the book value of the company one has to add all the assets and subtract the liabilities and divide the total by the number of shares. It is simple math however helps one understand the disparity between the price of the stock and the value of the company. Say the stock could be trading at $55.00 but the book value of the company could be say $13.00.

2.       Intrinsic value: Intrinsic value of the company stock is the actual value of the stock based on the perception of its true value in terms of both quantitative and qualitative factors (fundamental and technical analysis). Intrinsic value of the stock is derived without any regard to its market value.

3.       Market value: Market value is the value or the price the investors buy or sell the stock of the company. Market value is different from the book value as market value also takes into consideration the future price of the stock. For above average performing companies, the market value is always higher than the book value.

4.       Strategic value: Strategic value is the value that one company sets on another purely for business purpose. This value is derived and used mostly in case of mergers and acquisitions (M&A). The unique thing about calculating the strategic value is that it factors in the ‘synergies’. There are several factors which bring in synergies for mergers and acquisitions, new market segments, patents, human capital, vendor and competition. Strategic value is always case specific and depends on the synergies or the advantages a particular case may derive out of the business dealing. Historically, mergers and acquisitions have a high failure range (70% – 90%), that makes strategic value a very challenging and a complex subject.

While buying a stock, generally a common investor goes by the market value or applies a comparative model. The strategy also varies on the term of the investment, short term investors such as day traders need to keep a close watch on the market and may adopt different strategies whereas long term investors prefer compounded gains and adopt different set of strategies.

Valuation models

There are multiple valuation models available to value a project, asset or a business. Black Scholes, Capital Asset Pricing Model, Arbitrage Pricing model. Valuation models can be used to derive the value on an absolute basis as well as relatively. Absolute value is similar to intrinsic value, derived on the basis of company’s fundamental performance not compared with other companies. In contrast to absolute valuation models, relative valuation models operate by comparing the company in question to other similar companies.

We have included two models in our discussion both these models  calculate the value in absolute terms.

Valuation models

1. Earnings per share

This is the simplest form of valuation method, this type of value is simply earning per share as a percentage of the price of the share. For example if a share costs $10.00 and its dividend to shareholders is $1.00, its return on shareholder equity is 10%. Investors can use this as a tool and apply return to shareholder equity to a range of stocks and choose the most profitable stock. However this tool cannot be applied to companies who do not issue or issue very small sums of dividend, i.e. they roll back profits as retained earnings. The model example is Berkshire Hathaway. As we all know Berkshire Hathaway has never given any dividends, instead it rolls back the profits into the business on order to make further strategic investments, shareholders do not earn any steady income but the intrinsic value of the shares is always rising. In such cases, the market value keeps on increasing on account of retained earnings rolled back for expansion.

2. Discounted cash flow (DCF)

DCF is a method of valuing a company using the concepts of time value of money. DCF is a snapshot in time – today. All the future cash flows are determined and are discounted to give their net present value (NPV). Our grandmother used to buy movie ticket for $3.00 and today the same ticket costs us $12.00. So $3.00 of our grandmother is not the same $3.00 for us. The component of discounting to present value is important because $100.00 will not be worth of $100.00 in 5 years from today.

DCF = CF1/ (1+r)1 + CF2/(1+r)2 + CF3/(1+r)3 …+ CFn/(1+r)n

Where:
CF1 = cash flow in period 1
CF2 = cash flow in period 2
CF3 = cash flow in period 3
CFn = cash flow in period n
r = discount rate

Or

DCF

Step 1: Project the amount of operating cash flow the company is likely to produce in the years ahead, at least 5-10 years ahead.

Step 2: Determine how much those future cash flows are worth in today’s dollars by discounting them back to the present at a rate sufficient to compensate investors for the risk taken. The discount rate is very critical. If the inflation rate is say 2.5% and the rate of return on government bonds or savings account (risk free) is 4.5%, the discount rate will be 7.0% as one is losing out on 7.0% each year. If the cash flows are for 10 years the rate will be compounded for 10 years. For example if the sum of cash flows for 10 years is $100.00, the value of the cash flow in 10 years from now will be $51.00 only. ($100.00/1.97)

Step 3: Finally, divide that figure by the total number of fully diluted shares outstanding to arrive at a per-share fair value estimate.

Discounted Cash Flow is a very powerful tool used in deriving the values of stock, bonds and real estate.

Just as no value is absolute, no method or tool of investment is fool proof. Buffet’s philosophy lies in making long term investments in industries known to him. For instance he never invests in Information technology (IT) based companies as he says he does not understand IT sector. Buffet also believes in investing in companies which have durable competitive advantage such as insurance and chewing gums. Other experts suggest diversity is the best philosophy as it never places all eggs in one basket. Mutual funds, S&P Index funds and hedge funds also help reduce and spread out the risk and returns. Finally it all depends on how one thinks about the market.

 

References

How the Markets really work – by Del Kurtzman
Investopedia
The Street

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