Last week, I had posted a piece titled ‘Keeping Valuation Simple And Spook Proof’. The response to that piece came as a pleasant surprise to me, because to be perfectly honest I never expected that it would get the thumping response it got, so first off, a big thank you to everyone who took the time out to read the piece and respond. A lot of members who replied to that post had a common request. They wanted practical examples and insights to a more practical approach to valuation.
As the old adage goes, ask, and you shall receive. Starting today, and over the next few weeks, I will be doing a series focused exclusively on valuation, where we move from the basics, on to the advanced stuff, which will take you on a journey across the length and breadth of the world of valuation. I now present a brief outline of the structure of my series on valuation.
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Valuation 101-104: The basic course on valuation where we will discuss the basic and fundamental concepts of valuation.
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Valuation 201-204: The intermediate course where we will discuss valuation of companies across various stages of their individual life cycle, namely, birth, growth, maturity and decline.
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Valuation 301-304: The advanced course where we will talk about valuation of special types of companies such as financials, cyclicals, commodity companies, software and pharmaceutical companies and media companies, with which I will wind up the series.
With that being said, without further ado, lets get this show on the road. For today, I give you a brief outline of the fundamental concepts which are the building blocks of the world of valuation.
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Value: Value (not to be mistaken for price as it usually is) is the actual worth of something. If you’re looking at a car, the value is the actual worth of the car, if you’re looking at a house, the value is the actual worth of the house, and if you’re looking at a stock, the value is the actual worth of the stock.
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Valuation: Valuation is the process of arriving at the most accurate estimate of the value of an asset.
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Intrinsic Value: The intrinsic value of an asset is nothing but the worth of a particular asset by itself which is derived from its inherent characteristics. Almost everything has an intrinsic value. Even an individual, for that matter has an intrinsic value (derived from his/her inherent personality and value systems) The only things which are tough to value intrinsically are works of literature and art, because, in that case, the intrinsic value would depend on the beholder of the piece of art. When it comes to stocks, the characteristics which help in determining the intrinsic value of a stock are cash flows, growth rates, discount rates and terminal value.
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Relative Value: Relative value is the worth of an asset based on a comparison with assets with similar characteristics to the asset being valued, which are known as comparable assets. For example, if you want to relatively value an apartment in a particular area, you can do so by comparing the value of your apartment with other similar apartments in that particular area. In the case of companies and stocks, relative valuation is done by coming up with valuation multiples and other financial and accounting ratios and comparing them with valuation multiples and ratios of other firms in the same industry or sector.
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Free Cash Flow: This represents the amount that the owners of a company can take home in cash after paying for all necessary expenses, profits and debt repayments. Companies which have a free cash flow which is more than their net profits, are usually the most sought after, because it shows that they have liquid cash reserves in excess of the profits that they make. Free cash flows are usually discounted at a certain rate to their present value to help in arriving at the intrinsic value of the company.
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Value Drivers: These are also known as value enhancers. These are certain company specific characteristics that add value to the company and help the company’s stock command a premium in the market. For example, until Mr. Vishal Sikka recently stepped down at Infosys, the Infosys stock had a premium priced into it just because Mr. Sikka was on the board even though Infosys was not doing particularly well, which is also part of the reason why we saw such a sharp correction in the stock when he stepped down.
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Discount Rates: Discount rates represent risk in the future cash flows of the company. Discount rates are used to discount the future cash flows of a company to its present value, to see how much the company would be worth today, based on those future cash flows. Remember, riskier cash flows have higher discount rates, because it is that much more uncertain that the cash flows will accrue to the firm.
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Risk Free Rate: This is the minimum rate of return that future cash flows are expected to generate, irrespective of risk. The risk free rate is usually assumed to be the prevailing bank interest rate in the country, though that may not always be a fair assumption.
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Financial Balance Sheet: Accounting balance sheets are predominantly historical in nature, but equity investment is predominantly forward looking in nature. Hence accounting balance sheets have little to no use for all practical purposes when it comes to valuation. That’s where the financial balance sheet comes in. The financial balance sheet is just a slight tweak of the good old accounting balance sheet.On the assets side of a financial balance sheet, you only have Assets In Place (all existing assets of the company whether current or fixed) and Growth Assets(investments that we expect the company to make in both current and fixed assets in forthcoming periods, so in effect, we are giving the company credit for things they haven’t done yet). Coming to the liabilities side of a financial balance sheet, we again have two headings Equity (historical share capital) and Liabilities(unlike accounting balance sheets, here, current and long term liabilities are clubbed under a single heading). The biggest danger in valuing a company based on a financial balance sheet comes from the growth assets, in the sense that, the company may not make the investments we expect them to make, which may make our valuations unreliable.
So, that was a brief overview of some of the important fundamental concepts of valuation. I know this piece was a tad bit too dry and theoretical, but trust me, it only gets better from here. See you next week when we will have Valuation 102.