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Sam Ghosh Founder and SEBI Regd. Investment Adviser at Wisejay Private Limited Bangalore, Karnataka
Basics of Fundamental Analysis, part2: Valuation
In Investment Advisory
1 answer/comment
10:59:04 AM, 22nd November, 2018
  • Sam GhoshFounder and SEBI Regd. Investment Adviser at Wisejay Private LimitedBangalore, Karnataka
    Profile

    In part1 we learned how fundamental analysis is different from the technical analysis and different approaches to it. After the esoteric discussion, let us move to more tangible topics. As mentioned in part1, the fundamental analysis is based on a judgement of the value of a security. The variation of the market price of the value gives us buy and sell opportunities, but for that we need to judge the value of the security first. The process of judging the value is called valuation. I am calling it as a judgement because the value is often based on various assumptions and those assumptions are based on various judgement calls.


    There are three basic classes of valuation methods – Balance Sheet Methods, Discounted Cash-Flow Methods and Comparable Company Analysis.




    BALANCE SHEET METHODS

    1. Book Value Approach

    Book value is the value of shareholder’s equity presented on the balance sheet of a company. It is also called the net-worth of the company. It is calculated as the difference between the net assets and the liabilities of a company.

    The book value of a company can also be represented as the sum of equity share capital and all reserves (including revaluation reserve) and adjusted for expenses which are not written off.


    Although easier to calculate, the book value of a company is not a reliable measure of the value of the company for various reasons. Both the assets and liabilities are book value and may be significantly different from the value which can actually be realized. Apart from that, the value of a going concern is generally considerably higher than the value which can be realised from the sale of the assets and paying off the liabilities. Warren Buffett terms it as the economic goodwill of the company – the difference between the intrinsic value of a company and the book value.


    2. Adjusted Book Value Approach

    This approach makes some tweaks to the book value method by adjusting both the values of assets and liabilities by the fair market value. But, it still fails to consider the effects of intangible assets and contingent liabilities.


    3. Liquidation Value

    Consider the company stops to be a going concern and the owners decided to liquidate the company. They will sell the assets at fair market value (which can be an optimistic assumption because this situation will often represent a fire sale) and pay off the liabilities. Also, there will be some other expenses such as payments to employees and tax expenses. What is left is the liquidation value of the company.

    This valuation is useful in very specific cases – for example, when you are investing in a distressed company and you want to know what will be minimum value possible




    DISCOUNTED CASH-FLOW (DCF) METHODS


    1. Dividend Discount Model (DDM)

    Instead of valuing the equity of a company and then calculating value of securities, this method calculates the value of the share from projected dividend distributions. The basic DDM model assumes that the investor will hold the stock in perpetuity, dividends will grow at a steady rate and the discounted terminal value of the share is negligible.

    So, the value of the stock is represented as


    (Last dividend payout x (1+ dividend growth rate) ) / (Cost of Equity – dividend growth rate)

    The cost of equity is calculated using the Capital Asset Pricing Model (CAPM).

    DDM method is only useful in case of shares which has a history of steady dividend payment and is a going concern with predictable cash-flows.


    2. Free Cash-flow methods

    This methods assume that the value of the firm or the equity is the sum of the discounted values of the cash-flows to the firm or to the equity holders of the firm.

    Both the equity and the firm can be valued by projecting the Free Cash-Flow to Equity (FCFE) and Free Cash-Flow to Firm (FCFF) and discounting them with Weighted Average Cost of Capital (WACC) and Cost of Equity respectively.

    There is an implicit going concern assumption in these methods. These methods are not suitable for companies for which going concern assumption is not valid – for example for startups without a considerable operating history and for the companies in financial distress where the past results cannot be projected in the future. Also, it is difficult to project the cash-flows for the companies in cyclical industries.




    COMPARABLE COMPANY ANALYSIS

    This analysis assumes that comparable companies in the same industry should have similar valuation multiples such as EV/EBITDA, P/E, EV/Sales, EV/EBIT etc. So, we can determine the value of a company using the comparable companies.

    The primary factor determining the usefulness of this method is the skill in selecting appropriate comparables.

    The benefits of this method are that it is much simpler than the DCF methods and requires much less assumptions. It can also help us identify an undervalued stock in a sector.


    The issues with this analysis is that it fails to consider the risk and solvency factors in the balance sheet of a company. It assumes that if two companies are equally valuable is either they have similar operating income or net income per share. But, what if one company has a highly leveraged balance sheet which may result in insolvency during a difficult economic situation resulting in a bankruptcy? Risk is a primary factor in the valuation of a company and it cannot be ignored.

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