Company Analysis 3: Valuation Part 1

Valuation

Last weekend, my cousins decided to go for a trek, being a fitness enthusiast I quickly agreed and told my mom that we are going for a trek. Mom being mom somehow knew a farmers market there, she told me to bring some vegetables. I was okay with that anyways happy to go for a trek after a long time. I did bring fresh vegetables and mom was too happy to see it, but happiness lasted only till she knew the price I paid for those veggies. According to her, I paid at least twice the true value of the veggies. I told mom that I had already bought them at a 20% discount to what the vendor was initially pricing.  Anyways I surrendered after some time.

On the same day, one of my students came to me for presenting an analysis. He thought it could be a multi-bagger stock as the prices of the stock had already corrected 50% in the last few months. The analysis presented by him reminded me of myself arguing with mom on vegetable prices. I didn't know how to find true value for veggies and the student didn't know how to find the true value of a company. I anyways don't care to find the true value of veggies but an aspiring investor should definitely know how to value a company.

There are various models for finding the true value of a business. Such as:

• Asset-Based Valuation Model
• Market Approach/Relative Value Model (Already Discussed in an article on Ratio Analysis )
• Earnings Based Valuation Model

One may choose to master anyone or use a combination of all but for me, only logical valuation method is earning based. Let me discuss why? 

We as share buyers are investors in the company and the benefit we get from investing is from earnings only. If a company is willing to pay dividends it will pay us from earnings only. I have never seen a company paying investors by selling its assets or selling its shares at market price. If the source of benefit for us is in earning why should we distract ourselves to something that will never be used for paying us? I may be wrong with this argument but for me it is logical. 

Earnings Based Valuation 

In an earnings-based valuation model, we try to find future earning for the company, and based on that we value the company. Discounted Cash Flow (DCF) is a widely used valuation model. DCF became popular because we have seen Warren Buffet praising it over and over again. No doubt it is one of the best valuation models but I use a slightly modified version. We will first discuss the DCF valuation model and then the modified version so that understanding the modified version will be easier. One may choose to keep using the DCF model, the modified version is for those who want to eliminate errors due to wrong assumptions.

DCF Valuation Model

You must have heard your grandparents claiming that they used to buy groceries in less than a rupee. Today we hardly get a chocolate toffy for the same amount. Ever wondered why? Because the value of the currency has kept depreciating.1 rupee now does not have the same value as 1 rupee then similarly, 1 rupee 10 years later will not have the same value as 1 rupee today. This is the basic principle on which the DCF model works. In the DCF model, we try to predict the future cash flows of a company and find the present value of that future cash flow. This present value is considered as the intrinsic value of the company. 

Present Value= Future Cash/(1+Discount Rate)^Number of years

The discount rate is generally taken as the average FD rate of quality banks.

Let us consider a simple example of agricultural land. Agricultural land produces 1000 kg of rice every year. The selling price of rice today is 50 rs/kg and is expected to rise at a rate of 5% every year. The cost of growing (including seeds, fertilizers, pesticides, labor, and miscellaneous) is 20000 rs this year and will keep increasing at a rate of 5% each year. The average FD rate is 6% and we are taking land on a lease for 10 years what should we pay as a one-time payment for the lease is the intrinsic value of the land for 10 years.   

The table above shows calculations of future profits(we should use cash flows while valuing companies) and their present values. One can easily say that we should not pay more than the net present value of future cash flows. So we can say Net Present Value is the fair value of the land and paying any lower is better. Here in the example, we simply assumed a few variable but in real practice, things get a bit complex. So in the next article, we will discuss an example of a company and go deeper into the DCF model.

I hope you understood the basic concept of the DFC valuation model, if you have any query please feel free to comment. 

And don't forget to Read To Learn Investing.