Master the art of Valuation!

Welcome to the world of Equity research! Every now and then whenever I come across any equity research  or valuation report, I feel puzzled that how on earth a human being did such complex analysis? What are their assumptions? These reports haunted me a lot until I came across the blog of Prof. Damodaran . I followed his lecture slides religiously and tried to explore the world of valuation from Indian perspective. In the beginning I faced lot of difficulties but as I proceeded I saw the things are not as difficult as they seem to be. So, I got an idea to share my experience with you and help you to understand this weird world of analysis and valuations.

Before getting into any technical details, let’s first understand what valuation is and how can we do it from layman’s perspectives? Let’s assume that Ram is a shopkeeper and he wants to sell his business to third party. His shop is having a good reputation in nearby locality and is known for quality products and services. But since his family is planning to move to some other place, so he doesn’t have any other option then to sell his business. Now, the question is how can he value his shop? Should he sell it with the price equivalent to the costt of inventory he is having? (He does all his transactions in cash so no account receivables and payables)

Many of you who are reading this blog simply tell that he should sell his business equivalent to the cost of inventory he is having in his stores. This sounds rational too as there is nothing wrong in selling the business equivalent to the amount of inventory he possesses. But you are wrong and it is here where the role of valuation comes in to the picture. How? Simple, what is the cost of the name and fame that he gains for his shop from his sheer hardworking? What is the cost of the guaranteed income that you will earn by buying his shop? So, he shouldn’t sell his shop in just the amount equivalent to the inventory rather he must calculate the cash flow that he will generate from his shop and then discount it with the return that he is getting from its shop to get the actual value. He can easily get the return percentage from its past profit to calculate the true value of the firm.

Now, replace Ram’s shop with some big firm and repeat the same thing, you will get the valuation of the firm. But here you will have to subtract all the expenses and add depreciation, amortization etc. to get free cash flow which you will discount with the company’s cost of capital to get the actual value of the firm. Kindly remember that there lies lot of difference in the valuation of the firm and the Ram’s shop as the former involves lot of assumption and complex calculation which I will explain in my next post.

Be ready to explore the world of valuations with me from my next post  where I am going to explain the concept of discounted cash flow in Indian context.

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