Article by Investopedia:
Valuation is the process of determining the current worth of an asset or a company; there are many techniques used to determine value. An analyst placing a value on a company looks at the company’s management, the composition of its capital structure, the prospect of future earnings and market value of assets.
BREAKING DOWN ‘Valuation’
The market value of a security is determined by what a buyer is willing to pay a seller, assuming both parties enter the transaction willingly. When a security trades on an exchange, buyers and sellers determine the market value of a stock or bond. The concept of intrinsic value, however, refers to the perceived value of a security based on future earnings or some other company attribute unrelated to the market price of a security.
How Earnings Impact Valuation
The earnings per share (EPS) formula is stated as earnings available to common shareholders divided by number of common stock shares outstanding. EPS is an indicator of company profit because the more earnings a company can generate per share, the more valuable each share is to investors. Analysts also use the price-to-earnings (P/E) ratio for stock valuation, which is calculated as market price per share divided by EPS. The P/E ratio calculates how expensive a stock price is relative to the earnings produced per share. For example, if the P/E ratio of a stock is 20 times earnings, an analyst compares that P/E ratio to other companies in the same industry and to the ratio for the broader market.
Factoring in Stock Options
Intrinsic value is also used to assess stock options. Assume an investor buys a $50, or strike price, call option on XYZ common stock. The investor has the right to exercise the option and buy 100 shares of XYZ stock at $50 per share before the option expiration date. Intrinsic value is the difference between the current market price of the stock and the option’s strike price. If the current market value is $65 per share, the intrinsic value is $65 – $50, or $15 per share.
Examples of Discounted Cash Flows
Analysts also place a value on an asset or investment using the cash inflows and outflows generated by the asset. These cash flows are discounted into a current value using a discount rate, which is an assumption about interest rates or a minimum rate of return assumed by the investor. If a company is buying a piece of machinery, the firm analyses the cash outflow for the purchase and the additional cash inflows generated by the new asset. All of the cash flows are discounted to a present value, and the business determines the net present value (NPV). If the NPV is a positive number, the company should make the investment and buy the asset.
The intrinsic value is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value. Additionally, intrinsic value is primarily used in options pricing to indicate the amount an option is in the money.
BREAKING DOWN ‘Intrinsic Value’
Value investors who follow fundamental analysis typically look at both qualitative (business model, governance and target market factors) and quantitative (ratios and financial statement analysis) aspects of a business to see if the business is currently out of favour with the market and is really worth much more than its current valuation. The discounted cash flow model is one commonly used valuation method used to determine a company’s intrinsic value. The discounted cash flow model takes into account a company’s free cash flow and weighted average cost of capital, which accounts for the time value of money.
Intrinsic Value of Options
The intrinsic value for call options is the difference between the underlying stock’s price and the strike price. Conversely, the intrinsic value for put options is the difference between the strike price and the underlying stock’s price. In the case of both puts and calls, if the respective difference value is negative, the intrinsic value is given as zero. Intrinsic value and extrinsic value combine to make up the total value of an option’s price. The extrinsic value, or time value, takes into account the external factors that affect an option’s price, such as implied volatility and time value.
Intrinsic Value of Options Examples
Intrinsic value in options is the in the money portion of the option’s premium. For example, if a call options strike price is $15 and the underlying stock’s market price is at $25, then the intrinsic value of the call option is $10, or $25 – $15. Assume the option was purchased for $12, so the extrinsic value is $2, or $12 – $10. An option is usually never worth less than what an option holder can receive if the option is exercised. On the other hand, assume an investor purchases a put option with a strike price of $20 for $5, when the underlying stock was trading at $16. Therefore, the intrinsic value of the put option is $4, or $20 – $16, and the extrinsic value is $1, or $5 – $4. Assume that instead of purchasing a put option with a strike price of $20, the investor purchases a put option with a strike price of $15 for 50 cents, when the underlying stock was trading at $16. Therefore, the intrinsic value would be $0 because the option is out of the money. However, the option still has value, which only comes from the extrinsic value, which is worth 50 cents.
A type of large-cap stock investment where the intrinsic value of the company’s stock is greater than the stock’s market value. The stock’s intrinsic value can be determined by using a valuation model such as discounted cash flow and multiples.
BREAKING DOWN ‘Large-Value Stock’
A stock’s market value can fall below its intrinsic value for a number of reasons. For example, if a company seeks Chapter 11 bankruptcy protection, many shareholders could become concerned that the company will go bankrupt, and therefore sell their stock. If the company has enough assets to pay all of its liabilities, then there will be intrinsic value left in the company’s stock. This value may be greater than the stock’s market value, which results in a large-value-stock investing opportunity.
Relative Valuation Model
A relative valuation model is a business valuation method that compares a firm’s value to that of its competitors to determine the firm’s financial worth. Relative valuation models are an alternative to absolute value models, which try to determine a company’s intrinsic worth based on its estimated future free cash flows discounted to their present value. Like absolute value models, investors may use relative valuation models when determining whether a company’s stock is a good buy.
BREAKING DOWN ‘Relative Valuation Model’
Relative valuation uses multiples and benchmarks to determine firm value. A benchmark is selected by finding an average and that average is used to determine relative value.
Relative Valuation Multiples
There are many different types of relative valuation ratios, such as price to free cash flow, enterprise value (EV), operating margin, price to cash flow for real estate and price-to-sales (P/S) for retail. One of the most popular relative valuation multiples is the price-to-earnings (P/E) ratio. It is calculated by dividing stock price by earnings per share (EPS). A company with a high P/E ratio is trading at a higher price per dollar of earnings than its peers and is considered overvalued. Likewise, a company with a low P/E ratio is trading at a lower price per dollar of EPS and is considered undervalued. This framework can be carried out with any multiple of price to gauge relative market value.
How to Estimate Relative Value of Stock
In addition to providing a gauge for relative value, the P/E ratio allows analysts to back into the price that a stock should be trading at based on its peers. For example, if the average P/E for the specialty retail industry is 20x, it means the average price of stock from a company in the specialty retail industry trades at 20 times its EPS. Assume company A trades for $50 in the market and has EPS of $2. The P/E ratio is calculated by dividing $50 by $2, which is 25x. This is higher than the industry average of 20x, which means Company A is overvalued. If company A were trading at 20 times its EPS, the industry average, it would be trading at a price of $40, which is the relative value. In other words, based on the industry average company A is trading at a price that is $10 higher than it should be, representing an opportunity to sell. Due to the importance of developing an accurate benchmark or industry average, it is important to only compare companies in the same industry and market capitalization when calculating relative values.
Relative value is a method of determining an asset’s value that takes into account the value of similar assets. In contrast, absolute value looks only at an asset’s intrinsic value and does not compare it to other assets. Calculations that are used to measure the relative value of stocks include the enterprise ratio and price-to-earnings ratio.
BREAKING DOWN ‘Relative Value’
When value investors are considering which stocks to invest in, they do not just look at the financial statements of the companies whose stocks they are interested in buying to make sure that the company is profitable and well-managed and that the stock is under-priced. They also look at the financial statements of competing companies to assess the stock’s value relative to its peers.
An absolute value is a business valuation method that uses discounted cash flow (DCF) analysis to determine a company’s financial worth. The absolute value method differs from the relative value models that examine what a company is worth compared to its competitors. Absolute value models try to determine a company’s intrinsic worth based on its projected cash flows.
BREAKING DOWN ‘Absolute Value’
Finding out whether a stock is under or overvalued is a primary play of value investors. Value investors use popular metrics like the price to earnings (P/E) and price to book ratio to determine whether to buy or sell a stock based on its estimated worth. In addition to using these ratios as a valuation guide, the discounted cash flow (DCF) valuation analysis is another way to determine absolute value.
With a DCF model, some form of a company’s future cash flows (CF) is estimated and then discounted to the present value in order to determine an absolute value for the company. The present value is regarded as the true worth or intrinsic value of the firm. By comparing what a company’s share price should be, given its absolute value to the price that the stock is actually trading at, investors can determine if a stock is currently under or overvalued.
Examples of methods used under the DCF model include the dividend discount model (DDM), discounted asset model, discounted residual income method, and the discounted FCF method. All of these models require a rate of return or discount rate which is used to discount a firm’s cash flows – dividends, earnings, operating cash flow (OCF), or free cash flow (FCF) – to get the absolute value of the firm. Depending on the method employed to run a valuation analysis, the investor or analyst could use either the cost of equity or the weighted average cost of capital (WACC) as a discount rate.
For example, consider Tesla Inc. (TSLA) which is currently trading on the market for $370.50 (as of June 2017). After running a DCF analysis on its estimated future cash flows, an analyst determines that the absolute value of the firm is $450.30. This presents a buying opportunity for an investor who is led to believe, based on the numbers, that TSLA is undervalued.
Estimating a company’s absolute value is not without its setbacks. Forecasting the cash flows with complete certainty and projecting how long the CFs will remain on a growth trajectory is challenging. In addition to predicting an accurate growth rate, evaluating an appropriate discount rate to calculate the present value can be difficult. Since the absolute valuation approach to determining the worth of a stock is strictly based on the characteristics and fundamentals of the company under analysis, there is no comparison made to other companies in the same sector or industry. But companies within the same sector should be considered when analysing a firm, since a market moving activity (e.g. bankruptcy, government regulatory changes, disruptive innovation, employee layoffs, mergers and acquisitions, etc.) in any one of these companies can affect how the entire sector moves. Therefore, the best way to evaluate a stock’s real value is to incorporate a mix of both the absolute and relative value methods.
Rate of Return
A rate of return is the gain or loss on an investment over a specified time period, expressed as a percentage of the investment’s cost. Gains on investments are defined as income received plus any capital gains realized on the sale of the investment. Rate of return can also be defined as the net amount of discounted cash flows received on an investment.
BREAKING DOWN ‘Rate of Return’
A rate of return can be applied to any investment vehicle, from real estate to bonds, stocks and fine art, provided the asset is purchased at one point in time and produces cash flow at some point in the future. Investments are assessed based, in part, on past rates of return, which can be compared against assets of the same type to determine which investments are the most attractive.
The Differences between Stocks and Bonds
The rate of return calculation for stocks and bonds is slightly different. Assume an investor buys a stock for $60 a share, owns the stock for five years, and earns $10 in total dividends. If the investor sells the stock for $80, he has a $20 per share gain and has earned another $10 in income. The rate of return for the stock is $30 per share divided by the $60 cost per share, or 50%. On the other hand, if an investor pays $1,000 for a $1,000 par value 5% bond, the investment earns $50 in interest income per year. If the investor sells the bond for $1,100 and earns $100 in total interest, the investor’s rate of return is the $100 gain plus $100 interest income divided by the $1,000 cost, or 20%.
How to Discount Cash Flows
Discounted cash flows take the earnings on an investment and discount each of the cash flows based on a discount rate. The discount rate represents a minimum rate of return acceptable to the investor, or an assumed rate of inflation. In addition to investors, businesses use discounted cash flows to assess the profitability of a company’s investment. Assume, for example, a company is considering the purchase of a new piece of equipment for $10,000 and the firm uses a discount rate of 5%. After a $10,000 cash outflow, the equipment increases cash inflows by $2,000 a year for five years. The business applies present value table factors to the $10,000 outflow and to the $2,000 inflow each year for five years. The $2,000 inflow in year five would be discounted using the discount rate at 5% for five years. If the sum of all of the adjusted cash inflows and outflows is greater than zero, the investment is profitable. A positive net cash inflow also means the rate of return is higher than the 5% discount rate.
Fair value is defined as a sale price agreed to by a willing buyer and seller, assuming both parties enter the transaction freely. Many investments have a fair value determined by a market where the security is traded. Fair value also represents the value of a company’s assets and liabilities when a subsidiary company’s financial statements are consolidated with a parent company.
BREAKING DOWN ‘Fair Value’
The most reliable way to determine an investment’s fair value is to list the security on an exchange. If XYZ stock trades on an exchange, market makers provide a bid and ask price for XYZ stock. An investor can sell the stock at the bid price to the market maker and buy the stock from the marker maker at the ask price. Since investor demand for the stock largely determines bid and ask prices, the exchange is the most reliable method to determine a stock’s fair value.
How a Consolidation Works
Fair value is also used in a consolidation, which is a set of financial statements that presents a parent company and a subsidiary firm as if the two businesses are one company. This accounting treatment is unusual because original cost is used to value assets in most cases. The parent company buys an interest in a subsidiary, and the subsidiary’s assets and liabilities are presented at fair market value for each account. When the accounting records of both companies are consolidated, the subsidiary company’s fair market values are used to generate the combined set of financial statements.
Factoring in a Valuation
In some cases, it may be difficult to determine a fair value for an asset if there is not an active market for trading the asset. This is often an issue when accountants perform a company valuation. Say, for example, an accountant cannot determine a fair value for an unusual piece of equipment. The accountant may use the discounted cash flows generated by the asset to determine a fair value. In this case, the accountant uses the cash outflow to purchase the equipment and the cash inflows generated by using the equipment over its useful life. The value of the discounted cash flows is the fair value of the asset. The fair value of a derivative is determined, in part, by the value of an underlying asset. If you buy a 50 call option on XYZ stock, you are buying the right to purchase 100 shares of XYZ stock at $50 per share for a specific period of time. If XYZ stock’s market price increases, the value of the option on the stock also increases.
In the futures market, fair value is the equilibrium price for a futures contract. This is equal to the spot price after taking into account compounded interest (and dividends lost because the investor owns the futures contract rather than the physical stocks) over a certain period of time.
Asset valuation is the process of assessing the value of a company, real property or any other item of worth, in particular assets that produce cash flows. Asset valuation is commonly performed prior to the purchase or sale of an asset or prior to purchasing insurance for an asset. Asset valuation can be based on cash flows, comparable valuation metrics or transaction value.
BREAKING DOWN ‘Asset Valuation’
A large portion of financial theory is centred on asset valuation, and can include stocks, bonds, buildings, equipment and intangible assets such as brands, goodwill and labour. As a result, asset valuation often consists of both subjective and objective measurements. For example, there is no number on the financial statements that tells investors how much the company’s brand is worth; brand is an intangible asset and the valuation is subjective. On the other hand, net profit is an objective measurement based on the company’s income and expense figures. If a company is looking to acquire another company’s assets, it can look at the book value of assets, the market value of assets, and the transaction or replacement value.
Asset Valuation Methods
When valuing a company, analysts look at the book value of assets and the market value of assets. The book value is generally lower than market value because assets are listed at their historical cost. Common methods for determining an asset’s value include comparing it to similar assets and evaluating its cash flow potential. Acquisition cost, replacement cost and accumulated depreciation value are also methods of asset valuation. One of the most common ways to value assets is based on future cash flows. For example, the value of stock is based on future cash flows from dividends and share price appreciation. The value of bonds is based on the future cash flows of interest payments. The value of commercial real estate is based, in part, on rent. This method only works for assets that produce cash flows. If assets do not produce cash flows, the analyst can conduct a transaction analysis.
Relative and Transaction Asset Valuation
The most liquid assets can be traded on the market and therefore have a market value. Assets that have a market value are valued based on multiples of that value. For instance, stocks are often valued based on a multiple of price to earnings, price-to-book value or price-to-cash flows. These are relative market valuations. Transaction or replacement cost analysis seeks to find deals involving similar assets. This method is good for illiquid assets or assets with no market value. For example, home values go through cycles of demand. The best way to determine a value for your home is to compare it against similar home sales in the same area.
Asset Value per Share
An asset value per share is the total value of a fund’s investments divided by its number of shares outstanding. This type of asset value per share is more commonly referred to as “net asset value per share” or simply “net asset value” or “NAV.” Asset value per share can also refer to a public company’s total assets minus its total liabilities, divided by its number of shares outstanding. In this case, asset value per share may be referred to as “net current asset value per share.”
BREAKING DOWN ‘Asset Value per Share’
For most funds, asset value per share is the price at which shares in that fund can be bought and sold. For publicly traded companies, investors can use asset value per share to compare the price of the company’s stock to the underlying value of the company’s stock. Significant differences between these two numbers can indicate a prudent time to buy or sell.