Hi Friends! Hope you like my last post. I am sure that those who read my last post got slightest of idea about valuations. Now, my question is why we do the valuations? Because in my last post I did the valuations for a shop to make you people understand its concepts, but in reality Investors do it to find the true or intrinsic value of a firm. This help them in deciding to go for buying or selling decision of the firm’s stock based on its current market price.
One thing that puzzled me was that if there was something like true or intrinsic value of a firm, then why don’t investors simply do the valuations before investing in a firm’s stock and earn lot of money because true value always give the right value .And if they are doing so then why people are losing money in the stock market. So, is there something like true or intrinsic value for a company or it is just a myth? Now, my answer to this question is that valuation is based on future earnings, discount rate etc. and all these things depend on lot of assumptions and historical data. So, the value that comes out from the valuation is not actually the true value but a biased value based on many assumptions. That’s why if one read the equity resarch report from different agencies; one can find different value for the stock of the same company because every agency takes assumptions as per their own understanding about the company and its fundamentals. Hence, there is nothing like true or intrinsic value, but a biased value which gives us a rough idea about the company true value.
Now, one might ask that when the market price is available why should we do the valuation? Why don’t we directly refer the market price and make our decisions of buying and selling? There is no clear cut answer to these questions and therefore we make the most important assumptions of Valuations i.e. the markets are inefficient and make mistakes in accessing value because in an efficient market, the market price is the best estimate of value. That’s why we do the valuations to find out the rough estimates about the true value of the company stocks and then on the basis of our assumption of inefficient market, we make the decision of buying or selling.
There are many methods available for doing valuations but the most famous and commonly used method is discounted cash flow models (DCF). As the name suggests, this methods discount the future cash flow of a company to find out its present value (As explained by me for Ram’s shop in my last post). The basic of this model is the philosophy that “Every asset has an intrinsic value that can be estimated, based upon its characteristics, fundamentals growth and risks”. Hence, for investors who think to buy businesses rather than stocks while making investment, DCF is the best way to predict its value. Secondly, it is based on company fundamentals and intrinsic characteristics, so it is less exposed to market moods and perceptions.
Hope this post helps you to understand the basis of valuations and DCF.Be ready to explore the mysterious world of assumptions and complex calculation while doing valuations using DCF in my next post.