How to value a company?

Valuation of a company can be done in either of the following ways:

1. Valuation using cash flows.
2. Relative Valuation.




 Valuation using cash flows.

You could discount the future earnings of a company to arrive at the present value(intrinsic value)  by discounting the dividends(DDM - Dividend Discount Model), by discounting the operating cash flow to the firm(OCFF)  and by discounting the free cash flow to the equity(FCFE).

The cash flow for the concerned period can be estimated through a common size analyses of the concerned firm, wherein you benchmark each line in the P&L account against the sales or assets(based on the type of company one values). For example, I would use sales as the benchmark for a FMCG major and asset as a benchmark for a bank.

To proceed with any of the above valuation technique, you will have to first understand the discount rate(basically the required rate of return on your investment) and the growth rate(the rate at which the concerned asset class grows).

How to calculate the discount rate?

Suppose I want to calculate the required rate of return for my investment on RIL(oil and gas major in India). The required rate of return would be:

discount rate = Real Risk free Rate(RRFR) + Inflation Cover + Risk Premium on the equity.

Now for a country like India the RRFR would be 7%(return usually generated by government bonds) and the inflation premium would be 7%(since India is an emerging economy). The risk premium on equity will be its beta times the market risk premium(which is maket return - risk free rate). Suppose I input the market return as 10%(based on the dispersion from historical data) and the risk free rate is 7%(as mentioned above). Since Reliance moves with the market, I will input 1 for the beta.
This will give me a risk premium of 3{1*(10-7)} on RIL. Therefore, the discount rate comes to 17%(7+7+3).
From a company perspective, you seperately account for the financial risk, liquidity risk, country risk, exchange risk while calculating the equity risk premium.

How to calculate the growth rate?

The growth rate(g) = retention rate * ROE(return on equity), where retention rate = (1 - D/EPS). D/EPS is the dividend payout ratio.

You will need to use the growth rate and the discount rate when calculating the intrinsic value, using the DDM or the Infinite DDM. The discount rate will alone be enough when calculating the intrinsic value using the OFCF or FCFF. In case of the OFCF, you can use WACC(weighted average cost of capital) as your discount rate. In case of FCFE, you could directly use the cost of equity(described above).

Relative valuation

I have always believed that relative valuation is a much easier technique when compared to the discounted cash flow technique. Because, the different ratios are available in the Internet, and you don't have to forecast the cash flows, which according to me is the most challenging aspect of Valuations.

Using the relative valuation technique, you will be in a position to value a sector against the market. Once you select a sector, you can find firms, which are undervalued compared to the rest.

Though the process is fairly simple and straightforward, there is a hidden caveat. For e.g. the ever so famous PE ratio(which is Price per share divided by the EPS, either trailing or forward) fails to impress me when the earnings are negative(loss). In this case I will have to use my creativity to look for EP ratio(inverse of PE). the greater the EP ratio, the more undervalued is the company.

The P/B ratio( which is so frequently used to value financial institutions) also has some hidden caveat's. For eg:
1) A company, which has reported its assets on historical costs rather than the fair cost might have a misleading P/B.
2) A company, which uses LIFO(last in first out) to value its inventory rather than FIFO(first in first out) in an inflationary situation might distort its P/B.

BTW what is book value?

Book value = Common equity + Retained Earnings - Preferred equity.

Whatever be the valuation technique being used, a thorough scrutiny of the financial reports is a must before arriving at the intrinsic value of a company.