Investing in a stock is like buying a business. Unfortunately, most investors either don’t understand this principal or are merely looking for quick and easy money. In appraising businesses, there are three main approaches; market, asset and income.
The basic principal for this method is that it uses historical market data. The general theory is that if one can find sufficiently similar companies that have been sold in arm’s length transactions, then those transactions may form a basis for an indication of value for the interest being valued.
The common methods are price-earnings-ratio (PER) and price-to-book ratio (PB). Analysts normally compare these ratios with the industry or its historical figures.
PER = Market price ÷ Earnings per share (EPS)
If Company M’s PER is ten times against the industry’s fifteen times, Company M is undervalued.
PB = Market price ÷ Book value per share
If Company M’s PB is 1.5 times against the industry’s 2.0 times, Company M is lowly valued compared to the industry. Generally, if a company’s PB is lower than 1 time, it indicates that the market price is lower than the owner’s cost.
This approach is called adjusted book value, net asset value or asset accumulation. The book value of the assets and liabilities are adjusted to reflect its fair market value. The asset values are totaled and the total of the liabilities is subtracted to derive the total value of the company. The most common is the revised net asset value (RNAV) where analyst adjusts all its assets and liabilities to market value.
RNAV per share = (Revised assets market value – Revised liabilities value) ÷ number of shares
Company M is a holding company. Its subsidiary, Company N is also listed on the exchange. The RNAV will use the market value instead of the book value of Company N to determine the overall revised market value of Company M’s assets. The figure will provide a more reflective value for Company M as compared to its historical book value.
The income approach is the most appropriate method for valuing an ongoing company. An investment in any asset is worth no more than the present value of its expected future cash flow which can be in the form of earnings, dividends or free cash flow to equity.
The most common method used by analyst is single period capitalization method (SPCM). SPCM converts the single period of income into value by dividing it with a capitalization rate. This method relies on two assumptions; a stable annual financial return (which can be a proxy for every year in perpetuity) and a constant growth rate (which is a proxy for the annual compound growth rate in perpetuity).
Company’s value = Income ÷ Capitalization rate = [Cash flow x (1 + g)] ÷ R – g
Where: cash flow can be in the form of dividend per share (DPS) or free cash flow per share, g = the future growth rate of cash flow, R = the required rate of return for an investor, Capitalization rate = R – g
However, one of the main problems with this method is the accuracy of estimates of the company’s future dividend growth rate, i.e. ‘g’. Investors need to understand the company’s businesses and the potential of the company’s future earnings prospects before being able to provide a reasonable and accurate ‘g’.
Among the three approaches, the value indicated by the income approach is more appropriate and will have the greatest influence in valuing an operating company.