Stock / Share Market
by 5paisa Research Team Last Updated: 2022-09-19T18:14:18+05:30

Introduction

Before investing in a company, it is imperative to study its valuation. Company valuation involves analysing the economic worth of a business and its assets. It considers not only the current financial health but also its prospects.

Valuation is essential for the company itself and its investors. Valuation lets a company track its progress and measure performance against its competitors. Investors use valuations to determine the worth of potential and current investments. Typically, investors sell overvalued securities. and purchase undervalued instruments. 

Valuing a public company is more convenient than a private company. The data and information readily available for a listed company are significantly more than for a private company. Private companies do not publicly report their financial statements. Furthermore, there is no standardized stock exchange for private companies. Therefore, it isn't easy to ascertain the market price and capitalization of the company.

How to find the valuation of a company: Methods Of Valuation of a Company

Traditionally, the valuation of a company is the difference between its assets and liabilities. However, it may not always be an accurate measure. Therefore, financial experts choose one of the below methods to calculate company valuation. Here are the ways on how to determine company valuation:

1. Book Value 

One of the most straightforward methods to calculate company valuation is to calculate the book value from the data available on the balance sheet. To calculate the book value, subtract the company's liabilities from its assets to determine shareholder's equity, excluding the value of intangibles to value the tangible assets. 

While calculating book value is relatively easy, it may not be accurate. Experts believe balance sheet values may not represent company valuation. Historical cost accounting and conservative principles do not accurately represent the company's financial health and prospects. Additionally, the company's management prepares its financial statements, so there is scope for balance sheet window dressing. 
 
2. Discounted Cash Flows

These are the gold standard to calculate company valuation. It values the company based on the expected cash flows. As per the discounted cash flows method, valuation is a function of the present value of future cash flows based on the discount rate and period of analysis. 

The formula for valuation using the discount cash flows method is as below:
Valuation = Terminal Cash Flow/ (1+Cost of Capital) ^ Number of Years

The advantage of discounted cash flow method is the emphasis on the company's capability to produce liquid assets, i.e., terminal cash flow. It may be constant or vary for each period. However, the challenge with this valuation method is the accuracy of the terminal cash flow. Future growth, discount rates and terminal value depend on assumptions and may vary with time. 
 
3. Market Capitalization

Most market enthusiasts use market capitalization to gauge the size of a company, its valuation and industry share. For publicly traded companies, inputs for market capitalization calculation are readily available.

The formula for valuation using the market capitalization method is as below:
Valuation = Share Price * Total Number of Shares.

Typically, the market price of listed security factors the financial health, future earnings potential, and external factors' effect on the share price. A major shortcoming of the market capitalization model is it only accounts for the equity valuation, whereas most companies use a mix of debt and equity for financing. Debt represents investments by fixed-income security holders in the company's future. 
 
4. Enterprise Value

The enterprise value method deals with the limitations of the market capitalization method. It considers different capital structures such as debt, equity and cash or cash equivalents to value the company. 

The formula for valuation using the enterprise value method is as below:
Valuation = Debt + Equity – Cash

Since the enterprise value method factors in each source of Capital, investors can rely on the valuation to neutralize market risks. However, relying solely on enterprise value may be tricky for an industry with high debt levels. For other industries, high debt levels signify volatility and risk. Therefore, using enterprise value to determine company worth for high debt industries may lead to incorrect conclusions.
 

5. EBITDA 

While analyzing the financial worth of a company, analysts look beyond the net profitability of the company. At times, accounting conventions or deliberate manipulations may distort the true picture of company profitability. EBITDA refers to earnings before interest, tax, depreciation, and amortization. It is easier to explore ratios and evaluate the company using EBITDA. This valuation method aims to standardize a company's net profit for peer review. Tax liability and interest payment are common factors applicable to most companies.

Tax liability seems like an interruption from the actual company performance. It varies across countries or time, without actual changes in the company's operational capabilities. Similarly, interest payments to debt holders make a company seem more or less successful based on its capital structure. Analysts add taxes and interest to the net profit of the company to arrive at the operating profit.  

For companies with fixed assets, depreciation and amortization are inherent expenses. Suppose a company purchases a building or machinery; it may not record the transaction all at once. The business may charge itself an expense referred to as depreciation over time. Depreciation refers to the asset price reduction for wear and tear. Depreciation applies to tangible assets, and amortization is to intangible assets. The earnings of a rapidly growing company may seem bleak due to depreciation and amortization, even though it is not an actual expense. 

The EBITDA method makes it easier to compare the earnings from different companies. Nevertheless, it only considers earnings and not the company's capital structure or market value. 
 
6. Present Value of Growing Perpetuity Formula

Growing perpetuity is a financial instrument that pays a fixed income and grows yearly. For example, a pension after retirement pays regular income and needs to grow to match inflation. The growing perpetuity equation helps calculate the current value for that financial instrument. For some companies, EBITDA signifies growing perpetuity paid out yearly to its shareholders. 

The formula for valuation using the present value of the growing perpetuity method is as below:
Valuation = Cash Flow / (Cost of Capital – Growth Rate)
 
7. Price to Earnings Ratio 

The PE Ratio of an instrument is its market price divided by the earnings per share. Earnings per share is the PAT (profit after tax) divided by the number of shares. Typically, analysts use a historical record of PAT to avoid any distortions through accounting methods and tools. 
 
8. Price to Sales Ratio

Price to Sales Ratio = Market Capitalization / Annual Sales AND
Market capitalization = Current Market Price * Number of Shares

The PS ratio may not be as distorted as the PE ratio since misrepresenting the capital structure may not impact the annual sales. 
 
9. Price to Book Value Ratio

Price to Book Value Ratio = Current Market Price / Book Value

Value investors prefer the price-to-book value ratio since it denotes whether the instrument is expensive or undervalued. For example, a PBV ratio of 2 indicates the market price is Rs. 20 for a security with a book value of Rs. 10. 

Examples of how to calculate business valuation

Example 1

ABC Ltd and XYZ Ltd have a major market share in the automobile industry. Let's compare both companies using the enterprise value method. 
 
The market capitalization of ABC Ltd is Rs. 1500 crores, liabilities of Rs. 310 crores and cash or cash equivalents of Rs. 10 crores. Therefore, its enterprise valuation is Rs. 1800 (1500 + 310 – 10) crores. 
 
The market capitalization of XYZ Ltd is Rs. 1200 crores, liabilities of Rs. 825 crores and cash or cash equivalents of Rs. 25 crores. Enterprise valuation of ABC Ltd is 2000 (1200 + 825 – 25) crores. 
 
You may conclude the following:
 
●    The enterprise value of XYZ Ltd is more than ABC Ltd. 
●    The market capitalization of ABC Ltd is higher, and it relies on equity to finance its assets.
●    The debt exposure of XYZ Ltd is higher. Thus, the risk and volatility associated are also higher. 
 

Example 2

The current market price of PQR Ltd is Rs. 120 per share. The terminal cash flow value is Rs. 200 per share for the next five years. The cost of Capital is 10%. 
 
As per the discounted cash flow method, the value per share is Rs. 124.18 [Rs. 200 / (1 + 0.10) ^ 5]. The market price per share is Rs. 120. Since the market price is lower than its intrinsic value, there is a buying opportunity. 
 
To conclude, undervaluation presents a buying opportunity, while overvaluation indicates selling. 
 
 

Conclusion

Knowing how to calculate the valuation of a company is essential to understanding the true worth of the security. Investing in an overvalued security may hinder the capital invested. Therefore, apart from fundamental analysis, company valuation and ratio analysis help to assess investment viability. 

Simultaneously, the valuation of companies involves elaborate assumptions, guesstimates, and industry averages. There is also a certain degree of individual judgement and is prone to errors. To offset any margin for errors, experts recommend valuing security using at least two or three different models to corroborate the results. A trader with a holistic approach to company evaluation tends to perform successfully in the long run. 
 

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