When investing, the right place to pay for a stock is always vital and also very subjective due to the lack of information as well as difficulty in predicting the future.
Basically, there are three main approaches in deriving a company’s value, which are income, market and asset. Price-to-earnings ratio (PER), dividend yield (DY) and price-to-earnings ratio (P/BV) are categorized under the market approach, where the key principles behind these methods are dependent on their relative multiple against the market price.
For the asset approach, the valuation will be based on the fair market value of the company’s assets. Of the three approaches, income is the primary one used to value operating companies. It’s based on the principle that the company’s value will be derived mainly from the sum of the future benefits expected to be produced for the owner of the interest.
A rate of return or discount rate will then be used to discount all future benefits to the present value. It’s used to determine the fair market value of the normalized net operating assets.
There are two main components in the income approach, which are the appropriate future benefits and discount rates. The future benefits can be in any of the following forms like owner’s discretionary cash flow (ODCF), net income after tax, net income before tax, free cash flow, earnings before interest and tax (EBIT) and earnings before interest, taxes, depreciation and amortization (EBITDA). For investors, the discount rates are referred to as the required rates of return.
Most of the time, however, analysts have difficulty in deriving the above two components. If a business is complex, predicting its future benefits and discount rates with a high degree of certainty will be difficult and will also depend on the competency of the analysts projecting the future.
Among the above-mentioned future benefits, ODCF is the most important cash flow measurement to investors. ODCF is commonly defined as operating earnings before depreciation, interest, taxes one owner’s compensation. All compensation and operating expenses are adjusted to market.
This method provides a more realistic picture of the amount of money that will be available to pay to the owners of the business as a return on their investment. This method is usually used to find the value of a 100% or majority controlling interest in the company.
Usually, the main reason of most companies is to reduce tax payment. They will try their best to include a lot of expenses or have high salaries and director remunerations in order to reduce profit so that tax payments will be lower. Thus, there is a big difference between cash flow paid to the owner and cash flow distributed as dividends to other minority shareholders.
As a result, ODCF is superior to income-related future benefits like net income, pre-tax income, free cash flow, EBIT and EBITDA, as the latter are unable to provide the real picture of cash flow to a company’s owner. This is why some companies’ owners are willing to be involved in loss making companies for years.
Thus, the ordinary investors who have no control in the company’s operation need to be extra careful in picking the right company in which to invest. They need to select honest and competent owners who will always try their best to increase shareholders’ value.