Valuation analysis of a company may be required by investors, in case of business sale, to initiate a public offering process, or by analysts among other stakeholders. So, how does a valuation analysis work and what all aspects does it cover? While it may sound complex and technical, valuation analysis requires a basic and common understanding of a business and the various factors that impact business performance.
What is the meaning of valuation analysis?
Valuation analysis requires comparing the stock market value and financial parameters of a company’s stock to gauge its true worth.
Stock market values include:
- Current market price (CMP),
- Market capitalization (Mcap), among other factors,
Financial parameters included in valuation analysis include:
- Earning per share (EPS),
- Growth rate of EPS,
- Company sales,
- Shareholder’s equity,
- Sales growth rate,
- Book value,
- Dividend payout, etc.
Why is valuation analysis required?
After financial analysis, valuation analysis acts as a second level check for stock performance.
It helps in estimating whether a company’s stock is trading at appropriate price levels or is overvalued.
After conducting financial analysis to gauge the strength of a company, an analyst can proceed towards conducting valuation analysis, which helps in checking whether the company’s stock is priced correctly.
In case a company’s shares are overvalued, it is best to avoid investing in them. Investing in overvalued stocks can result in high levels of investment risk and lowers the potential of capital appreciation in the future. Valuation analysis is therefore important for taking an investment decision around any company’s stock.
What are the different valuation analysis techniques?
The 3 main valuation analysis techniques that are commonly adopted by investors are:
Market-based approach
This method of valuation analysis involves selecting:
- a comparable company within the same sector and having similar business
- the right variable and
- the right multiple
The commonly used multiples under this method are:
- Price to book value (P/BV): This method is especially used for the valuation of companies that mostly depend on their asset value for income, for example, banking. Using this multiple, analysts can know whether the company’s stock is expensive.
- Price/Earnings (P/E): This ratio requires using profit after tax as a multiple to arrive at the company’s equity value. Although frequently used, the results from this multiple can be distorted due to various accounting adjustments and also the company’s capital structure. For P/E to fetch accurate results, a company must have a consistent profit track record.
- EV/EBITDA: EBITDA or Earnings Before Interest, Taxes, Depreciation, and Amortisation is preferred by analysts for valuation analysis since it takes away the effects of a company’s non-operating income, capital structure, and different tax rates, thereby minimising distortions. Since these are earnings before interest, the numerator value used is the Enterprise Value, also known as the value of debt, equity, and cash balance.
- Price/Sales (P/S): This is considered easy to calculate and is not impacted by a company’s capital structure, therefore not distorted when compared to the P/E ratio. It is often used to analyse companies in the retail sector that have inconsistent profits.
Asset-based approach
Asset-based approach, which includes estimating a company’s Net Asset Value (NAV) is one of the easiest valuation techniques.
NAV is:
- The fair value of a company’s assets minus external liabilities of the company.
An analyst must estimate the fair value of assets in this case because the fair value may be substantially different from acquisition value, especially in the case of non-depreciating assets and also the recorded value of depreciating assets.
The fair value of a company’s net assets can be significantly different from the value derived by simply adding the net asset prices. To improve the NAV calculation, analysts may use the Replacement Cost Method, which takes into account the value of assets that any individual who is of the importance of the business may pay for establishing a business exactly the same as the present one. This method helps analysts arrive at the value of a stock.
Income-based approach
Under this method, investors mainly use the Discounted Cash Flow (DCF) technique, which involves the calculation of the present value of a company’s future cash flows. Here, discounting is done to arrive at the present value using the company’s cost of capital.
- If cash flows to the firm are used, it results in enterprise value = value of debt + equity
- If cash flows to shareholders are used, it gives Equity Value
Which valuation method is best?
After considering all three methods, an investor may still want to clarify which method to pick? The answer depends on:
- Available data or information
- Which method is suited to what situation, sector, and business-type
- What levels of detail are expected
It is not necessary for an investor or analyst to use value estimates of a single method at a time. They can use a combination of methods mentioned above and use their average to prepare the final valuation of a company.
Conclusion
No one wants to invest in an overvalued stock that may heighten the risk of capital loss. Hence, before investing in a stock, an investor must conduct a valuation analysis of a company. This will help in understanding the true worth of the stock. Investors often use a combination of fundamental analysis, valuation analysis and ratio analysis to gauge an investment’s worth.
FAQs
Fundamental analysis is used to value stocks by evaluating their intrinsic or fair value. Technical analysis is also used for stock valuation by evaluating the charts and price trends to predict future stock prices.
Both fundamental and technical analysis are equally important while determining the true worth of a stock and the company. While the technical analysis may mostly help short-term investors, fundamental analysis supports long-term investors in decision-making.
Depending on the technique used, valuation analysis uses a combination of past and present data to derive the true value of a company and assist in decision-making.
Valuation analysis involves the use of quantitative analysis to gauge a company’s true value. Some of the factors used include cash flows, the fair value of assets, and the earnings performance of the company.
Value investing is an investment technique used by investors to identify stocks that are currently trading at prices lower than their intrinsic or true value. This is often used by seasoned investors who possess market know-how and some level of industry expertise to gauge the true value of a company.
