Basic Tools for Valuation
There
seem to be a few prominent financial forms of valuation used in different
circumstances. Below is a short list of some of these valuation methods for
assessing either the value of money in the future, the payoff of an investment
or valuing the stock of a company.
- Perpetuity - A stream of equal cash flows that occur at regular intervals and last forever. Present Value = Cash flow / rate
- Annuity - A stream of N equal cash flows paid at regular intervals. Payment has a set end time after a fixed number of payments.
- Discounted Free Cash Flow model - a method of valuing the total value of the firm to all investors both equity and debt holders. The biggest difference in using this model to value a firm is that you discount the free cash flow that will be paid to both debt and equity holders.
- Enterprise Value = market value of equity + Debt - Cash
- Market Value = Enterprise Value - Debt + Cash
- Price Earnings Ratio = Share price / Earnings per share - “The intuition behind its use is that when you buy a stock, you are in a sense buying the rights to the firm’s future earnings.”
What does history tell us about the process of financial valuation
of a firm?
John Burr Williams, the “founder of fundamental
analysis” is quoted saying “the truth is that the mathematical method is a new
tool of great power whose use promises to lead to notable advances in
Investment analysis. Always it has been the rule in the history of science that
the invention of new tools is the key to new discoveries, and we may expect the
same rule to hold true in this branch of Economics as well.” (p. 278).
William’s book Theory of investment value
was written in 1938 and marked the beginning of the use of formal analytical
mathematical methods in finance.
I found it unsettling when Williams refers to
using mathematical methods in finance as an ‘invention’ of a new tool. While
this is may be true, I question if it is ethical to be doing? Most mathematicians
will tell you that math is not an ‘invention’ it is merely a discovery of an
existing and provable set of interconnected universal laws. Laws pertaining to
the functions of our universe like gravity or matter. When using mathematics to
figure out something as mysterious and unproven as the value of something I
feel there is subtle level of subjective manipulation occurring. Unlike the
mathematics that prove the existence of gravity, we still struggle to account
for the full value of things on this planet.
There are so many assumptions that must be made in order for one number
to represent or mean anything in relation to a firm’s value that it makes
valuation less of a mathematical process and more of a judgment call.
This brings me to the heart of valuation, the
art of making assumptions. I turn to a major Investment Nerd, Douglas Kehring, who
explains the process behind valuing a company and readying it for the market (p.
292 Interview) He notes that, once they want to try and acquire a company, they
“Negotiate the price point with the seller - that’s where the art comes into
play. Our DCF (Discount Cash Flow) Analysis is the most important part in
justifying the value.” Typically they use 5 year DCFs and he explains that the
hardest part of the analysis is in determining the inputs,
“assumptions are key” he says. They also take into
account the income statement and breakeven valuations so they can get a hold on
a firms current standing.
As we move forward into a more sustainable,
profitable and accountable world, I feel like the process involved in making
assumptions is our biggest point of leverage. If we can begin to make
assumptions that account for the value of our planetary capital, social and
human capital as well as our manufactured and financial capital then we could
really start to get closer to true valuations. Of course there are plenty of forecasters
and investment firms that know how to play the game of valuation and make the
proper assumptions but is there work truly reflective of the value of the firms
they examine? We have a lot of room to evolve our process for valuation and I
look forward to a day when we can account for a firm’s value beyond financial
performance.
Hi Tatianna, Your points about assumptions resonated with me a lot. I agree, so much of valuation modeling comes down to what assumptions are being used to derive the estimates. I think we are often in a hurry to look at the end number without digging into the assumptions that underpin those numbers. It is a good reminder to me to always be cautious when reviewing valuations. To dig. To ask questions. To question assumptions. It’s tricky with modeling because I feel like you can easily start to manipulate your model to get the answers you want. In addition to the art of assumptions, I think you are right – we also need to be learning the art of negotiation. I think those two together offer powerful tools for better integrating more aspects into the valuation process.
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