Every day thousands of market participants such as retail investors, portfolio managers, pension fund managers, regulators and researchers participate in the stock selection process.
Every day thousands of market participants such as retail investors, portfolio managers, pension fund managers, regulators and researchers participate in the stock selection process. All of them have a common and often perplexing question: What is the value of a particular share? The answers to this question usually determine success or failure in achieving investment objectives. Let us make an attempt to arrive at an answer for the above question.
What is value?
To determine value received for money paid one should understand the concept of relative value. This is nothing but the prospective differences in risk-adjusted return offered by different shares at current market prices. In order to arrive at the same we need to engage the process known as valuation. Valuation is the estimation of an asset’s value based either on variables perceived to be related to future investment returns or on comparisons with similar assets. Generally, valuation of a particular company is a task within the context of the portfolio management process.
Each individual valuation can be viewed as a process with the following steps:
Understanding the business
Understanding a company’s economic and industry context and management’s strategic responses are the first tasks in understanding that company. Because similar economic and technological factors affect all companies within the industry and therefore industry knowledge helps to understand the basic characteristics of the markets.
Forecasting company performance can be viewed from two perspectives: the economic environment in which the company operates and the company’s own financial characteristics. Industry analysis and competitive analysis take place within the larger context of economic analysis. As an approach to forecasting, moving from the international and national macroeconomic forecasts to industry forecasts and then to individual company and asset forecasts is known as a top-down forecasting approach.
Financial forecasting integrates the analysis of industry prospects and competitive and corporate strategy with financial statement analysis to formulate specific numerical forecasts of such items as sales and earnings. One can consider qualitative as well as quantitative factors in financial forecasting and valuation.
Choosing the right valuation model
Several value perspectives are available in the investment science literature. Amongst all intrinsic value perspective is the most popular one. Though, intrinsic value perspective is popular one should not ignore other concepts of value such as going-concern value, liquidation value, and fair value.
The intrinsic value of an asset/share is the value of the asset given a hypothetically complete understanding of the asset’s investment characteristics.
The going-concern value of a company is its value under a going-concern assumption. Once established as publicly traded, most companies have relatively long lives.
A company’s liquidation value is its value if it were dissolved and its assets sold individually. For many companies, the value added by assets working together and by human capital applied to managing those assets makes estimated going-concern value greater than liquidation value.
Liquidation value should be distinguished from what is sometimes called the break-up value or private market value of a company, which is the sum of the expected value of the company’s parts if the parts were independent entities.
The higher of going-concern value or liquidation value is the company’s fair value. If the marketplace has confidence that the company’s management is acting in the owners’ best interests, market prices should on average reflect fair value. Fair value is the price at which an asset (or liability) would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell.
Apart from the above, we do have absolute valuation model that specifies an asset’s intrinsic value. Models such as discounted cash flow model, dividend discount models are the examples.
How do you select a valuation model?
The broad criteria for model selection are that the valuation model should be consistent with the characteristics of the company being valued; appropriate given the availability and quality of data; and consistent with the purpose of valuation.
Valuation of a share is a skill which can be learned by following the above steps and this skill is an essential element of successful investing.
The writer is associate professor of finance & accounting, IIM Shillong