The Basics of Company Valuation: Exploring Two Simple Approaches
Demystifying Company Valuation: Learn Two Approaches for Investing in Value Stocks
Hey everyone,
Today,
I'm going to talk to you about how to start and approach the valuation of a company.
The valuation of a company is the key point of the value investing strategy because this is where we will find the value of a business and compare it with the actual price.
As an investor, our strategy is to find companies that are valued below the market and expect growth in the future.
To do this, we need to do a valuation of the company to make the decision to invest or not.
In order to understand how to value a company.
I studied the book « The little book of valuation » by professor Aswath Damodaran and his free courses on YouTube, which is the legend of a company valuation.
(Link at the end)
Often, most people fear business valuation because they think it is a very complex task.
But the Professor said :
I believe that valuation, at its core, is simple, and anyone who is willing to spend time collecting and analyzing information can do it.
Aswath
In this article, I do not describe how to carry out the valuation methods in detail, but only the approach by which they should be approached.
The complete method will be dedicated in another article.
Quick Summary:
100+ valuation models and metrics but only 3 valuation approaches:
Intrinsic Valuation or Discounted Cash Flow
Relative Valuation or Pricing approach
Contingent Valuation (not studied)
Discounted cash flow valuation assumes that markets can make mistakes, which may affect entire sectors or the entire market.
Relative valuation assumes that although markets may make mistakes on individual stocks, they are generally correct on average.
Table of content :
I. What is a valuation?
II. 3 Myths about valuation
III. What are the approaches to valuation?
IV. To conclude
I. What’s a valuation ?
A company's valuation is an estimate of its worth or value. It is a calculation that attempts to measure the company's financial performance and potential.
Valuations are typically done for a variety of purposes, such as:
Investment: Valuations are often used by investors who are considering investing in a company, as they want to understand the potential return on their investment.
Acquisition or Merger: Valuations are also used when companies are considering acquiring or merging with another company. The acquiring company will want to know the target company's value before deciding on the terms of the acquisition.
Accounting and Tax Purposes: Companies may also have to conduct valuations for accounting or tax purposes, such as determining the value of assets for financial reporting or tax compliance.
Litigation and Legal Proceedings: In legal proceedings such as disputes between shareholders or divorce proceedings, valuations are often used to determine the value of a company and its assets.
In our case,
We are focusing on value companies to decide if it’s undervalued and could be a potential investment. I leave the rest to the bank.
II. 3 Myths about valuation
However, it's important to note that valuations are not an exact science and can be influenced by a variety of factors, including market conditions, economic trends, and industry-specific factors.
Myth 1: A valuation is an objective search for "true" value
In reality, all valuations are biased. So, the only questions are "How much and in which direction ?"
Myth 2: A good valuation provides a precise estimate of the value
In reality, there no precise valuations
And the payoff to valuation is greatest is least precise.
Myth 3 : The more quantitative a model, the better valuation
In reality, Your understanding of a valuation model is inversely proportional to the number of inputs required for the model.
Simpler valuation models do much better than complex ones.
III. What are the approaches to valuation?
The use of a valuation model is performed to make an investment decision.
Intrinsic Valuation
The intrinsic value of an asset is determined by the cash flows you expect that asset to generate over its life and how uncertain you feel about these cash flows.
Relative Valuation
In relative valuation, assets are valued by looking at how the market prices similar assets.
1. Intrinsic Value or Discounted Cash Flow (DCF)
What is it?
Philosophical Basis: Every asset has an intrinsic value that can be estimated, based on its characteristic in terms of cash flows, growth, and risk.
Information Needed :
Estimation of the life of the asset
Estimation of the cash flows during the life of the asset
Estimation of the discount rate to apply to these cash flows to get the present value
Discount rate reflects the risk of those cash flows.
Advantages of DCF :
Less exposure to market mood and perception.
That allows you to think about what you are getting when you buy an asset
It forces you to underlying characteristics and understands business. (Business competition, the market,...)
If you invest in a company that generates cash flows then you are immune to what the market thinks of the company because you will receive the fruits of that tree.
One of the things Warren Buffet has said is he doesn't buy share in a company but a piece of business. If you truly believe that, intrinsic valuation is what you should be doing right.
Aswath Damodaran
Disadvantages of DCF :
It requires far more explicit inputs and information than other valuations.
Inputs and information are difficult to estimate and can be manipulated by analysts.
No guarantee that anything will be under or overvalued.
Possibility to find every stock overvalued.
You have to hope that the walker recognizes his mistake and goes
When DCF works best?
It is a model that is designed to analyze companies with assets that generate cash flows.
For long-term investment (Because the time it takes for the market to recognize its mistake can be long)
So, gold, currencies, and collectibles cannot be valued.
This will allow you to identify an entry price in a business.
Some people are natural contrarians, if you were the kind of kid in school, you might be a good candidate for intrinsic valuation because you're going to be able to handle the fact that nobody else agrees with it. That you're doing things that everybody else thinks is stupid.
Don't estimate the psychological aspects of what makes intrinsic valuation work for you.
Aswath Damodaran
2. Relative Valuation
What is it?
Relative valuation involves comparing the market prices of various companies in order to identify potential bargains. This method of valuation is based on the pricing of similar assets in the market.
For instance, when considering the purchase of a house, a buyer might evaluate the price by examining the prices of comparable houses in the same area.
Information needed :
The 3 essential steps in relative valuation are:
1. Find comparable assets that are priced by the market.
2. Scale the market prices to a common variable to generate standardized prices that are comparable across assets
3. Adjust for differences across assets when comparing their standardized values.
Aswath Damodaran
Advantages of Pricing
Pricing reflects more the market perceptions than DCF.
Pricing requires less explicit information than DCF
Disadvantages of Pricing
Pricing assumes that the market is right and therefore can indicate over- and undervaluations.
When does pricing work best?
Pricing is easiest to use when :
There are a large number of assets
These assets are priced in a market
It works for investors who have short time horizons, and a mispricing opportunity in the market.
Which one to choose?
Discounted cash flow valuation assumes that markets can make mistakes, which may affect entire sectors or the entire market.
In contrast, relative valuation assumes that although markets may make mistakes on individual stocks, they are generally correct on average.
Intrinsic valuation provides a fuller picture of what drives the value of a business or stock, but there are times when relative valuation will yield a more realistic estimate of value. In general, there is no reason to choose one over the other, since nothing stops you from using both approaches on the same investment.
To conclude,
100+ valuation models and metrics but only 2 valuation approaches. There is a third one which is the Contingent claim approach (or real option).
Contingent claim augments the value of assets, whose cash flows are contingent on an event happening.
This approach is still unclear to me, but I will devote a special study to it.
As for the other two valuation methods.
Case studies will be carried out in order to put the valuation into practice.
The art of invests,
Sources :
The little book of valuation by Aswath Damodaran(