Company valuation methods

The way companies are valued makes one wonder if there is any rational method in the process. Erratic stock prices have put fundamental and technical analysts in a spot. How does one explain price hike spikes if more than 20-30% in a day? Different research houses use different valuation methods to arrive at their target price. But how is an ordinary investor to make sense of these and make an informed decision?

Before a methodology is chosen, the projections of the company’s financials are made. Then, depending on the sector in which the company operates and its future growth potential, a suitable methodology is adopted. Three of the most commonly used methodologies are Discounted Cash Flow, Price / Earnings Multiple, and Sum of the Parts.

Discounted Cash Flow (DCF) is the amount an investor is willing to pay today, in order to receive the anticipated cash flow (cash the company generates) in future years. In short, the DCF method converts future earnings into today’s money. The future cash flows are discounted to represent their present values, using a rate that aptly depicts the risk associated with the company. The rate used is the weighted average cost of capital (WACC).The key parameters required in advance for calculating DCF value are:

Projection of future cash flows, terminal growth rate, amount of debt on the books, equity portion of capital employed, cost of debt and calculations for cost of equity.

The advantage here is that this methodology is least exposed to market moods and perceptions. The flip side is that one needs a lot of data to calculate the DCF value, which is difficult to gather.

The Price / Earnings ratio or P / E multiple is one of the easiest methodologies used. The P / E is a ratio that divides the current stock price by either trailing earnings per share (EPS) or forecasted EPS for the company. The ratio by itself tells us little. It has to been seen in comparison with P / E multiple for the company’s peer group and the industry average (which varies widely).

The growth of the company is a key element when using the P / E multiple as a valuation tool. For example, Indian IT stocks, which were registering a compounded annual growth rate (CAGR) of more than 30% during FY02- FY07 in earnings traded at 20-25 times their P / E multiples. However, with growth expected to slow down the stocks have been re-rated to lower P/E multiples of 15x-18x.

The Sum of Parts Methodology is an increasingly used tool these days, especially as many companies are diversifying into businesses other than their original business. This method values different parts of a company’s business using the most appropriate method for the segment, ad then sums up the values to arrive at the company’s fair value. Under this methodology, sector specific multiples are used. Let’s take the example of Reliance Industries Ltd which is in the oil and gas exploration business, refining of crude oil, distribution of petroleum products, manufacturing of petrochemicals, organized retail, and the setting up of SEZs. Remember, it was originally just a textile company. Each part of these businesses is valued using different methodologies.

The value of oil and gas exploration business is calculated using DCF or EV / barrel (Enterprise Value) of oil equivalent of its oil and gas reserves. The refining and petrochemicals business is valued on EV / EBIDTA or replacement costs of its assets. The distribution business value is calculated on a replacement costs basis. The value of the organized retail business is calculated as EV per square foot of retail area setup, and that of SEZ is calculated by ascribing a value per acre to the total area being developed.

Another important element in any quoted investments held by the company. In the case of RIL, its 70.99% stake in Reliance Petroleum and treasury holding (RIL holding its own shares) are taken into account. After summing up the values of all businesses and quoted investments, we arrive at a total enterprise value of the business.

The next step is to calculate derived market capitalization by subtracting debt and adding cash to enterprise value. The value so arrived at is then divided by outstanding number of shares to get the sum of parts value for the company. The methodology is lengthy and taxing, as it requires lot of inputs besides an understanding of various sectors.

Sector-specific multiples which one should keep in mind are EV / ton of capacity for cement, metals, and so on, and Price / Book value for banking and financial services.

A look at the share price can hardly tell you the real value of a company. Although valuation methods cannot be ignored for the meaningful insights they provide into a company’s growth prospects, in a world of tips and speculative swings, valuations still remain a big question mark.