Valuing Investments: Understanding The Core Principle

The main principle used for valuing an investment is the determination of its current or projected worth. This process, known as valuation, involves assessing the economic value of an asset, investment, or company. While there are several methods for valuation, the fundamental principle remains the same: to estimate the fair value of the investment based on its future cash flow potential, market position, and intrinsic value. By analysing financial statements, market data, and future projections, investors can make informed decisions about the value and potential of an investment.

Discounted cash flow analysis

Discounted cash flow (DCF) analysis is a method of valuing investments that estimates the value of an investment based on its expected future cash flows. It is a widely used technique in both the investment industry and corporate finance management.

DCF analysis involves discounting the projected future cash flows of an investment to determine its present value. This present value is then compared to the current cost of the investment to assess its potential profitability. If the DCF is higher than the current cost, the investment is likely to generate positive returns and may be worth pursuing.

DCF analysis can be applied to value stocks, companies, projects, and other assets. It is particularly useful for valuing privately-held companies and can also be used as an "acid test" for publicly traded stocks.

The first step in conducting a DCF analysis is to estimate the future cash flows and the terminal value of the investment over a specific time period, such as the investment horizon. The terminal value represents the expected future value of the investment at the end of the projection period.

The next step is to determine an appropriate discount rate, which reflects the cost of capital. The discount rate can vary depending on the project or investment and is typically based on the company's weighted average cost of capital (WACC). The WACC takes into account the relative proportion of debt and equity in a company's capital structure.

By applying the discount rate to the future cash flows, investors can calculate the net present value (NPV) of the investment. The NPV represents the difference between the present value of the future cash flows and the initial investment amount. A positive NPV indicates that the investment is likely to generate returns higher than the initial cost, making it a potentially profitable opportunity.

DCF analysis provides a reasonable projection of the potential returns of an investment. It allows investors to make informed decisions by considering the time value of money, which assumes that money available today is worth more than the same amount in the future due to its potential for investment and growth.

However, one of the limitations of DCF analysis is its reliance on estimates and assumptions about future cash flows, discount rates, and terminal values. Accurate estimation is crucial for the reliability of DCF results, and unforeseen economic changes or market fluctuations can impact the accuracy of these estimates.

Market capitalisation

For example, if a company has 20 million shares selling at $100 a share, its market cap would be $2 billion. If another company has a share price of $1,000 but only 10,000 shares outstanding, its market cap would be $10 million.

Market cap is used to determine a company's size and is often used as a baseline for analysis. Companies are grouped by market cap size, from nano-cap companies worth less than $50 million to mega-cap giants worth over $200 billion. Market cap is also used to rank the relative size of stock exchanges.

Market cap helps investors assess risk. Larger-cap companies typically offer more stability but slower growth, while smaller-cap companies often have greater potential for growth but more risk.

It is important to note that market cap only accounts for the value of equity, while most companies are financed by a combination of debt and equity. A more comprehensive measure of a company's size is enterprise value (EV), which takes into account outstanding debt, preferred stock, and other factors.

Earnings multipliers

The earnings multiplier can be a useful tool for investors to determine how expensive the current price of a stock is relative to the company's earnings per share of that stock. This is important because the price of a stock is theoretically supposed to be a function of the anticipated future value of the issuing company and future cash flows resulting from ownership of that stock. If the price of a stock is historically expensive relative to the company's earnings, it may indicate that it's not an optimal time to purchase this equity because it's overly expensive.

For example, consider a company with a current stock price of $50 per share and earnings per share (EPS) of $5. The earnings multiplier would be 10 years, meaning it would take 10 years to make back the stock price of $50 given the current EPS.

Comparing earnings multipliers across similar companies can help illustrate how expensive various companies' stock prices are relative to one another. For instance, if company XYZ has an EPS of $5 and a current stock price of $65, it has an earnings multiplier of 13 years. Consequently, this stock may be deemed relatively more expensive than a company with an EPS of $5 and a current stock price of $50, which has a multiplier of 10 years.

The earnings multiplier should only be used to value investments on a relative basis and should not be used to gauge an absolute valuation of a stock.

Business valuation models

Business valuation is the process of determining the economic value of a business. It is often used during the merger or acquisition of a company but can also be used to determine fair value for sale, establishing partner ownership, taxation, and even divorce proceedings.

There are several methods used to value a business, each providing a different view of a company's value. No method is inherently more correct than another, and the tools used for valuation can vary among evaluators, businesses, and industries. Here are some of the most common business valuation models:

• Market Capitalization: This is the simplest method of business valuation. It is calculated by multiplying the company's share price by its total number of shares outstanding. However, it does not account for debt that an acquiring company would have to pay off or cash on hand that would offset that debt.
• Times Revenue Method: This method involves applying a stream of revenues generated over a certain period to a multiplier that depends on the industry and economic environment. For example, a tech company may be valued at 3x revenue, while a service firm may be valued at 0.5x revenue.
• Earnings Multiplier: This method provides a more accurate picture of a company's value by adjusting future profits against cash flow that could be invested at the current interest rate over the same period. It adjusts the current P/E ratio to account for current interest rates.
• Discounted Cash Flow (DCF) Method: The DCF method is similar to the earnings multiplier method and is based on projections of future cash flows, which are adjusted to get the current market value of the company. It also considers inflation in calculating the present value.
• Book Value: This is the value of shareholders' equity in a business as shown on the balance sheet. It is derived by subtracting the company's total liabilities from its total assets and excluding any intangible assets.
• Liquidation Value: Liquidation value is the net cash a business would receive if its assets were liquidated and its liabilities paid off today.
• Enterprise Value: This method combines a company's debt and equity and then subtracts the cash amount not used to fund business operations.
• Precedent Transactions: This method compares the company in question to similar companies that have recently been sold or acquired in the same industry.
• Comparable Company Analysis: This is a relative valuation method that compares the current value of a business to other similar businesses by looking at trading multiples like P/E, EV/EBITDA, or other multiples.
• Ability-to-Pay Analysis: This approach looks at the maximum price an acquirer can pay for a business while still hitting a specific target, such as a hurdle rate.

Liquidity

Volume and bid/ask spread

While there are no hard rules to determine whether an asset is liquid or illiquid, you can analyse its bid/ask spread and volume to get a good idea. The bid is the highest price an investor is willing to pay for a stock, and the ask is the lowest price at which an investor is willing to sell. A consistently large bid/ask spread implies a low trading volume for the stock, while a consistently small bid/ask spread implies high volume.

The illiquidity premium

Illiquid assets tend to have higher expected returns (a risk premium) as compensation for their incremental risks and higher costs of trading. Larger, long-term investors such as pension plans and insurance companies can use the associated risks to their advantage and diversify their portfolios with illiquid assets such as real estate, farmland, and infrastructure. This is often described as the illiquidity premium.

Mutual funds and ETFs

Mutual funds and exchange-traded funds (ETFs) are highly liquid, but the liquidity of the fund's holdings is a vital component in this agreement. Rules introduced by the Securities and Exchange Commission (SEC) seek to prevent the same issues affecting US investors by insisting fund managers provide greater transparency around their holdings. Managers must now classify their fund's holdings into four liquidity categories: highly liquid investments, moderately liquid investments, less liquid investments, and illiquid investments.

Examples of liquid and illiquid investments

• Money markets are the closest thing to cash in the investment world. They are very liquid and have very little fluctuation, making them a safe and dependable investment.
• Traditional bank savings accounts are just as liquid as having cash in a checking account.
• Annuities are notorious for their lack of liquidity. They are designed to create an income stream and it is often impossible to remove the lump sum or a portion of it once it has been invested.
• Stocks and bonds are best viewed as having very little liquidity. It is possible to access the money fairly easily, but in most cases, it is best left alone as leaving the money invested for a period of time ranging from one year or more is often required to recoup the original investment.

Frequently asked questions