Equity Valuation versus Firm Valuation

There are two ways in which we can approach discounted cash flow valuation. The first is to value the entire business, with both assets-in-place and growth assets; this is often termed firm or enterprise valuation.

The cash flows before debt payments and after reinvestment needs are called free cash flows to the firm, and the discount rate that reflects the composite cost of financing from all sources of capital is called the cost of capital. The second way is to just value the equity stake in the business, and this is called equity valuation.

The cash flows after debt payments and reinvestment needs are called free cash flows to equity, and the discount rate that reflects just the cost of equity financing is the cost of equity. Note also that we can always get from the former (firm value) to the latter (equity value) by netting out the value of all non-equity claims from firm value. Done right, the value of equity should be the same whether it is valued directly (by discounting cash flows to equity a the cost of equity) or indirectly (by valuing the firm and subtracting out the value of all non-equity claims). 

Classifying Discounted Cash Flow Models

There are three distinct ways in which we can categorize discounted cash flow models. In the first, we differentiate between valuing a business as a going concern as opposed to a collection of assets. In the second, we draw a distinction between valuing the equity in a business and valuing the business itself. In the third, we lay out three different and equivalent ways of doing discounted cash flow valuation – the expected

cash flow approach, a value based upon excess returns and adjusted present value. 

Going Concern versus Asset Valuation

The value of an asset in the discounted cash flow framework is the present value of the expected cash flows on that asset. Extending this proposition to valuing a business, it can be argued that the value of a business is the sum of the values of the individual assets owned by the business. While this may be technically right, there is a key  difference between valuing a collection of assets and a business. A business or a company is an on-going entity with assets that it already owns and assets it expects to invest in the future.

Investments that have already been made are categorized as assets in place, but investments that we expect the business to make in the future are growth assets. A financial balance sheet provides a good framework to draw out the differences between valuing a business as a going concern and valuing it as a collection of assets. In  a going concern valuation, we have to make our best judgments not only on existing investments but also on expected future investments and their profitability. While this may seem to be foolhardy, a large proportion of the market value of growth companies comes from their growth assets. In an asset-based valuation, we focus primarily on the assets in place and estimate the value of each asset separately. Adding the asset values together yields the value of the business. For companies with lucrative growth

opportunities, asset-based valuations will yield lower values than going concern valuations.

One special case of asset-based valuation is liquidation valuation, where we value assets based upon the presumption that they have to be sold now. In theory, this should be equal to the value obtained from discounted cash flow valuations of individual assets but the urgency associated with liquidating assets quickly may result in a discount on the value. How large the discount will be will depend upon the number of potential buyers for the assets, the asset characteristics and the state of the economy.

Approaches to Valuation

Analysts use a wide spectrum of models, ranging from the simple to the sophisticated. These models often make very different assumptions about the fundamentals that determine value, but they do share some common characteristics and can be classified in broader terms. There are several advantages to such a classification -- it makes it is easier to understand where individual models fit in to the big picture, why
they provide different results and when they have fundamental errors in logic. In general terms, there are three approaches to valuation. The first, discounted  cash flow valuation, relates the value of an asset to the present value of expected future cash flows on that asset. The second, relative valuation, estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings, cash flows, book value or sales. The third, contingent claim valuation, uses option pricing models to measure the value of assets that share option characteristics. While they can yield different estimates of value, one of the objectives of this book is to explain the reasons for such differences, and to help in picking the right model to use for a specific task.


Discounted Cash-flow Valuation

In discounted cash flows valuation, the value of an asset is the present value of the expected cash flows on the asset, discounted back at a rate that reflects the riskiness of these cash flows. This approach gets the most play in classrooms and comes with the best theoretical credentials. In this section, we will look at the foundations of the approach and some of the preliminary details on how we estimate its inputs.

Basis for Approach
We buy most assets because we expect them to generate cash flows for us in the future. In discounted cash flow valuation, we begin with a simple proposition. The value of an asset is not what someone perceives it to be worth but it is a function of the expected cash flows on that asset. Put simply, assets with high and predictable cash flows should have higher values than assets with low and volatile cash flows. In discounted
cash flow valuation, we estimate the value of an asset as the present value of the expected cash flows on it.

The cash flows will vary from asset to asset -- dividends for stocks, coupons(interest) and the face value for bonds and after-tax cash flows for a business. The discount rate will be a function of the riskiness of the estimated cash flows, with higher rates for riskier assets and lower rates for safer ones.Using discounted cash flow models is in some sense an act of faith. We believe that every asset has an intrinsic value and we try to estimate that intrinsic value by looking at an asset’s fundamentals. What is intrinsic value? Consider it the value that would be attached to an asset by an all-knowing analyst with access to all information available right now and a perfect valuation model. No such analyst exists, of course, but we all aspire to be as close as we can to this perfect analyst. The problem lies in the fact that none of us ever gets to see what the true intrinsic value of an asset is and we therefore have no way of knowing whether our discounted cash flow valuations are close to the mark or not.

INTRODUCTION TO VALUATION

INTRODUCTION TO VALUATION


Knowing what an asset is worth and what determines that value is a pre-requisite for intelligent decision making -- in choosing investments for a portfolio, in deciding on the appropriate price to pay or receive in a takeover and in making investment, financing and dividend choices when running a business. The premise of this blog is that we can Emake reasonable estimates of value for most assets, and that the same fundamental
principles determine the values of all types of assets, real as well as financial. Some assets are easier to value than others, the details of valuation vary from asset to asset, and the uncertainty associated with value estimates is different for different assets, but the core principles remain the same. This chapter lays out some general insights about the valuation process and outlines the role that valuation plays in portfolio management,
acquisition analysis and in corporate finance. It also examines the three basic approaches that can be used to value an asset.

A philosophical basis for valuation A postulate of sound investing is that an investor does not pay more for an asset than it is worth. This statement may seem logical and obvious, but it is forgotten and rediscovered at some time in every generation and in every market. There are those who  are disingenuous enough to argue that value is in the eyes of the beholder, and that any price can be justified if there are other investors willing to pay that price. That is patently absurd. Perceptions may be all that matter when the asset is a painting or a sculpture, but we do not and should not buy most assets for aesthetic or emotional reasons; we buy financial assets for the cash flows we expect to receive from them. Consequently, perceptions of value have to be backed up by reality, which implies that the price we pay for any asset should reflect the cash flows it is expected to generate. The models of valuation described in this book attempt to relate value to the level of, uncertainty about and expected growth in these cash flows.


There are many aspects of valuation where we can agree to disagree, including estimates of true value and how long it will take for prices to adjust to that true value. But there is one point on which there can be no disagreement. Asset prices cannot be justified by merely using the argument that there will be other investors around who will pay a higher price in the future. That is the equivalent of playing a very expensive game of
musical chairs, where every investor has to answer the question, "Where will I be when the music stops?” before playing. The problem with investing with the expectation that there will be a bigger fool around to sell an asset to, when the time comes, is that you might end up being the biggest fool of all.


Inside the Valuation Process 

There are two extreme views of the valuation process. At one end are those who believe that valuation, done right, is a hard science, where there is little room for analyst views or human error. At the other are those who feel that valuation is more of an art, where savvy analysts can manipulate the numbers to generate whatever result they want. The truth does lies somewhere in the middle and we will use this section to consider three components of the valuation process that do not get the attention they deserve – the bias that analysts bring to the process, the uncertainty that they have to grapple with and the complexity that modern technology and easy access to information have introduced into valuation.

Value first, Valuation to follow: Bias in Valuation

We almost never start valuing a company with a blank slate. All too often, our views on a company are formed before we start inputting the numbers into the models that we use and not surprisingly, our conclusions tend to reflect our biases. We will begin by considering the sources of bias in valuation and then move on to evaluate how bias manifests itself in most valuations. We will close with a discussion of how best to minimize or at least deal with bias in valuations.

Fundamental Analysis!!!

To arrive at Fair Valuation of a company what we require is lots of data, so that we are better equipped while forecasting its future income and hence paying and adequate price for it today!!! These data needs to be not only gathered but sorted and adjusted to level of your estimation too.
The sources to these data’s are endless; what’s more important is to set a pattern for our research activity based on which we can get data and analyze them one by one.
There are two different ways in which analyst may start their research activity.
1. Top –Down Research approach
2. Bottom-up Research approach
Top-Down Research approach: In this approach analyst doesn’t have any particular company at first to analyze but rather take a Countries Economy. Typically it starts with analyzing Economies across the comparable country, then analyzing Industries within the Economy, and then companies within the sector, finding an undervalued growth opportunity and then Investing. (please note I have used Analyzing the economy/industries/company with reference to a comparable, which simply put refers to one of the basic rule of analysis that when we analyze a company it cannot be done on a standalone basis and has to be relative, & compared with other economies/companies but of the same size, We cannot compare a developing or underdeveloped economy with a developed one, neither can we compare a multinational with a local business group irrespective of their presence in the same business.

Bottom-up Research approach: Against Top down in Bottom-up Research Analyst has a company or a script which is analyzed beforehand with comparable, moving then to the industrial performance and its growth prospective and then moving on to the Economy as a whole.

Need and Application of an analysis!!!!

One of the most debatable matters between Fundamental and Technical analyst has been the very need of doing an analysis. Why should we care about the monetary policy or fiscal policy of a country, why analyze a whole Industrial sector, why analyze a company’s management their accounts, forecast their future etc.? When we can buy/sell a stock and buy/sell it as soon we realize our profits (on the basis of demand and supply of stock or volume and trend of a stock or technical reasons discussed latter, I have written buy/sell here because in stock market you can sell a stock first even when you don’t own any stock and buy it latter at lower price and give the shares back, realizing the profit known as shorting).
Well this can be done purely on technical basis but not for a long term basis (I cannot predict what will be volumes or number of shares been traded in the market a year down the line) and by buying today selling tomorrow and repeating this over a period of time even in a stock which is doing good and is in upward trend we are reducing our profitability and exposing our self to the trading risk, only making our brokers rich.
The primary and most important reason for analyzing with such details and precision is to get the Fair value of a stock and the company that we are about to buy to be able to realize its future gains? This is the crux of value investing/Equity analysis. It’s actually more important for an investor that what price are you buy something than what are you buying. That is why Brand such as Reliance power was a bad buy when it was listed at 540 levels & satyam computers was a good buy at 40 levels even after all the hassle it has gone through.By saying that we need to buy something at fare price I mean the actual value of the shares or the company should be equal to market price. (Please note I am using value and price as two different terms as they are never the same, price is defined as the markets willingness to pay you “x” amount against one share of a company, by Value I mean fair price that I should receive today considering the future potential of a business).This makes it our Rule number 1 for our Investment
1) FAIR VALUATION
Now how to calculate the fair value of a share will be discussed over the topic before which I need to cover some prerequisite for arriving at fair valuation, which will be discussed in my next post.
Other Applications of Analysis
In financial world, Analysis is one of the most important aspects of the industry, not only in stock market/Equity market but also as a part of Economic research and forecast, Industrial research, Private Equity market (space where venture capitalist/other companies acquire other non-listed private company)

Most important Anlaysis

With an assumption that we are here to analyse Equity value of a company i.e. the business of which share is underlying asset off, I have to safely assume that we all are clear with basics of accounting and finance, I will still try to cover up basic as much as I can.
Before we start analysing a script or a share I think the most fruitful exercise would be to analyse ourselves as an individual and our objective from this, it’s obvious that we all have a common objective of earning profits but we all are different individuals and carry different belief and concept about this market. Many or in fact all of us at some time or other has hoped/imagined that the script we just bought would fetch us hundred times profit if not thousands. I wouldn't say that can never happen but buying and hoping script goes up isn't always fruitful. I come across many people who say “I don’t put my money in stock market any-more  because whenever I did, the moment I did the stock prices tanked down, guess we are not made for each other.” I generally don’t react to it.
The best thing to start out would be to set our objectives straight to be able to strategies our way out
· What Am I here for?
· What kind of patience level do I have?
· What can be the time period of your investments?If your answers to these three questions are 1) here to make quick bucks, 2)no patience level, 3)less than one year/shorter the better, then you can safely put yourself in traders category and will require to develop a different set of skills (There is nothing wrong in being under traders horizon against the conventional belief, it’s just the skills require to succeed in the market with this object would be different (known as technical analysis) than what we are talking about here. (I am still learning about technical analysis and would add a blog on it soon.)
If your answers to these questions are 1) I am here to make money I don’t mind if it takes time as long as I learn from it too. 2) I have Patience, but doesn't mean I am stupid. 3) As long as the company is earning/sharing profits and growth prospectus is high I don’t mind 2yrs 5yrs 10yrs 20yrs…. Then you will need skills called as fundamental skills to analyse and can put yourself in the horizon of Investors.

There is nothing wrong in having both answers and objectives, ultimately whatever makes money for us….i put myself in both the categories too but then my portfolio is clearly divided into 25-75 horizon not more than 25% with a trading objective and out of that not more than 10% for speculative reasons if not all with a logical trading view. But before I did that I had to make sure I understand both views of analysis and rules of both the game which are like two very different animals. You too can design your own portfolio weight-age and put money accordingly till the time you are clear with the reasons for your call.
With the objectives clear we can then proceed to see what does the most intelligent people on the wall- Street does and how can we all share the title of an Analyst.