We have now reached the culmination of our Financial Modelling adventure. The ultimate step is to create a valuation model that we will incorporate into the integrated model. Valuation models are designed to evaluate the worth of a company on a per-share basis and while there are various methods to build one, they all culminate in gauging how much each share is worth.
The idea behind the valuation process is straightforward; we evaluate the company and deduce its share cost. We call this the reasonable price of the firm’s stock, taking into account all essentials in our model and its assumptions, schedules and so on. Eventually, we draw a conclusion by contrasting the fair price of the company to its current market value on the stock exchange.
Overvalued, if market price > fair price
Undervalued if market price < fair price
Fairly valued if market price = fair price
Valuations provide investors with the knowledge of the price they should pay for acquiring a stake in a business. Through three distinct techniques, we are able to determine the worth of a company. These methods include
Option based valuation
Option based valuation
In this chapter, I’ll provide a concise overview of the three methods that’ll aid you in seeing things from different angles. We will then proceed to further explore one method and come up with ways of applying it in our financial model in the next several chapters.
– Relative valuations
Theory of relative valuation asserts that if two companies are similar in terms of their business, products, size, geographic spread, financials and subject to the same regulations, then their valuations should be comparable. As an example, TCS and HDFC Bank should not be compared as they are not alike; however, comparing HDFC Bank with ICICI Bank – both private sector banks – would bring up apt results. Similarly, Infosys and TCS or Bajaj Auto and Hero MotorCorp could also be compared. Various other firms with similarities in their operations can also be evaluated to arrive at reliable conclusions.
We can place this information in context. Let’s consider that only three businesses exist in the nation which produce automobiles. Their profits after tax, coupled with their respective stock prices, are shown below.
Company 1 – PAT is Rs.100, a stock trading at Rs.1005 per share
Company 2 – PAT is Rs.220, a stock trading at Rs.2185 per share
Company 3 – PAT is Rs.75, a stock trading at Rs.785 per share
If you do a simple ratio check i.e. dividing the company’s stock price by its profitability (measured in terms of PAT), we get the following results –
Company 1: 1005/100 = 10.05x
Company 2: 2185/220 = 9.93x
Company 3: 785/75 = 10.46x
By looking at the figures, it is clear that the sector is approximating a 10x market capitalisation for its earnings. If a 4th company with similar dynamics were to enter the market, and had an income of Rs.300, what would be its stock valuation?
By performing the relative valuation approach, we can roughly estimate that the stock price should be Rs.3000. But if the actual figure is higher or lower, it implies the stock is overvalued or underpriced accordingly. While this example just uses one ratio to showcase the relative valuation process, there are multiple other ratios which you could look into.
Conducting relative valuations on companies is usually straightforward for investors, as it follows an intuitive format and industry norms. However, its use has some drawbacks too.
The markets could be mispricing the industry, with very high valuations assigned in certain cases (as was seen in the dot com era). Alternatively, they may assign extremely low prices, due to a difficulty in comprehending the business models.
No two companies are alike. Each has its own nuances that can influence valuations. For instance, if the fourth car manufacturer mentioned previously had a revenue of Rs.600, then a 50% PAT margin would be a remarkable achievement, and this could lead to the market assigning it a greater value.
As investors, we need to take into account other valuation techniques as well. So, let’s take a look at the options-based valuation before shifting our focus to absolute valuations.