The price of an investment is attractive only if it is less than its underlying value. However, many investors place too much emphasis on the price of an investment and not on the value that they are getting. The bedrock of an enduring investment philosophy is “valuation”. Whether it is investing in bonds or investing in equities, the principle is the same. We need to figure out the price at which the investment becomes compelling.
1. Initial Value of the investment
2. Return earned on that investment
3. Investment Yield which is a function of the return earned
4. Time Horizon
When it comes to investing in equities, it is important you make an informed decision that has a solid analytical foundation. Equity investing is peppered with common words like value investing, intrinsic value, worth of the company etc. In simple terms, valuation is the process to determine the worth of a particular company or asset based on the information available in the market. Following are two most common methods to measure the value of a company:
· Intrinsic Valuation
· Relative Valuation
Intrinsic Valuation is the process that helps you discover the value of a company based on publicly available information whereas, relative valuation includes comparing different multiples of the companies from the same sector or industry. To determine intrinsic value, one can use different types of valuation models like the Dividend Discount model (DDM), Free Cash Flow to the Firm (FCFF) model and Free Cash Flow to equity methods.
To arrive at the intrinsic value of a company one needs to make various assumptions like future revenue growth, risk-free rates, various margins etc. For relative valuation, multiples like Price/Earning, EV/EBITDA, EV/Revenue etc. are used. New business models like those of Netflix, Twitter, Uber etc., have forced valuation experts to make changes to their models as the existing methodologies were unable to capture the true value of such companies. These are subscription-based models that behove the need to factor “value per subscriber” into the valuation process.
Capital asset pricing model (CAPM) is famous among investors to capture the market risk through beta. Arbitrage pricing model, Fama-French model and multifactor models are detailed variants of CAPM, which consider different risk factors like volatility, firms size (midcap, small cap and large cap) etc., to arrive at an appropriate value for the investment. Ascertaining the intrinsic value of a company can be very complex and tedious job. You need to work with reams of past data and then arrive at future projections in order to determine a justifiable number.
Often, investors are unable to differentiate stock price and stock value. Price is something that you pay to acquire a stock and hold the stock until its value is realised. One needs to be confident in their assumptions and valuation method because in a group of 100 people you will find 100 different values of the same stock but a single purchase price. However, the value of stock needs to be updated by factoring new information like earnings announcement, expansion, dividends payment etc. received during regular intervals. In simple terms, valuation provides you with the entry and exit point to invest in any company.