We all do our research when buying stocks. We research the company, its fundamentals, financials and future prospects. But it is also important to understand whether stock prices given by the markets actually reflect its true value. Now, it is very important to understand that, even though the terms price and value are sometimes used interchangeably, they mean two very different things. Price is the rate at which a stock is selling on the market, and value, is what a stock is actually worth.
Now, the great thing about the stock market is that, stocks worth 100 rupees sometimes sell for 50, and stocks worth 50 sometimes sell for 100. So yes, it is important for us to try and value a stock before investing in it to make sure we’re striking an attractive deal. But the second you say valuation, numbers and mathematical models come to the fore. And let’s face it, most of us get bogged down and spooked out by big numbers and complex calculations, and most of us may be scared that our valuations may be wrong. But this piece is designed to help you make valuation a lot simpler, and to help you understand valuation a lot better.
Professor Aswath Damodaran, in his book, The Little Book Of Valuation (a fantastic book which every aspiring valuer cannot miss reading), starts by saying that valuation, contrary to popular belief, is simple, and that anyone on the planet can do valuation. To justify his stance, Professor Damodaran has prescribed a set guidelines, that should be at the heart of every attempted valuation, and I will now be sharing those very same guidelines.
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Put in your best effort: When doing a valuation it is important to remember not get bogged down and throw in the towel before the game of valuation even starts. Put in your best effort, and if you still end up being wrong with your value, well, remember that you are only human, and that the more companies you value, the better you get.
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Even the best valuations are estimates: We think that because numbers and mathematical models are involved in valuation, we are more than likely to end up with an accurate value. But this couldn’t be farther from the truth. Valuation is actually an applied science and not an exact science, and will always be affected by uncertainty. Ergo, every valuation, no matter how meticulously it is done, no matter by whom it is done (when I say by whom, I mean these so called market experts and analysts) is always an estimate, because it all depends on how the valuer applies the principles of valuation. So if the experts are no better at valuation than you are, why not do it yourself?!
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Less is more: We sometimes feel that the more data we have available to us, the better our valuation estimate is likely to be. But, using more data when you can effectively value with less data, is nothing more than a case of too many cooks spoiling the broth (or in this case, too much data spoiling the valuation). So, if you can come up with an effective valuation using three years worth of data, don’t try and use five years worth of data.
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Bring your knowledge to the table, not your biases: When we start valuing a company we sometimes have preconceptions about the company. These preconceptions may be positive or negative, and our valuations sometimes get influenced by these preconceptions ( we value a company we like higher than one we don’t). So it is important for us to keep our valuations objective, and to remember that if even the best companies are exorbitantly priced relative to their value, it is best to stay away. And always remember that valuations given by experts are usually biased because they are paid to come up with their valuations.
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If something doesn’t affect the value, it shouldn’t effect your valuation: Continuing on the topic of experts and valuation, when one company merges with another, or acquires another, experts push up valuations of these companies to exorbitant heights, justifying the valuations by attributing them to buzz words like synergy, control, brand name, goodwill etc which are likely as a result of the merger. But ask these ‘experts’ to elaborate on these buzz words and how they affect the value, well, lets just say that statues are more likely to talk than some of these experts are. So, you shouldn’t pay a premium for something that is not guaranteed to affect the value.
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Growth doesn’t necessarily increase value: Companies which grow consistently, invariably sell at a premium compared to others, because of their growth potential. But growth achieved without stability and/or proportionate growth in revenues and profits is of no use. So, only the right kind of growth adds to value.
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Don’t decide beforehand: Don’t make your mind up to buy or sell a stock before you value it, because if you do, you are more than likely to do everything possible to make your valuation justify your decision, even if you have to use the wrong means to meet your end.
So these were a few general guidelines with respect to valuation which you can keep in mind when you are valuing the next stock or the next company you are interested in buying. So now that you are armed with these guidelines, what are you waiting for? Go out there and play the game of valuation to your heart’s content