Modules for Investors
Advanced Fundamental Analysis - Valuation
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The End Game: Why is valuation important?
In the previous module, we learnt extensively about fundamental analysis, the techniques involved, and how they can help you choose the right company to invest in. However, the main purpose or end result of fundamental analysis doesn’t just stop with helping you pick the right stocks. It is to help you make an objective assessment of whether the stock that you’ve picked is worth the price that it is currently trading at. That’s the end game of fundamental analysis - valuation.
As you’ve already briefly read about in the previous chapter, valuation is nothing but the process through which you evaluate the worth of a company’s stock. Okay, so you know what valuation is. But why should an investor do it? What can an investor hope to achieve by determining the value of a stock? If these are some of the questions that are running on your mind, then you’ve come to the right place. In this chapter, we will try to understand how to get to the valuation stage and why valuation is necessary, in the first place.
Let’s look at an example to better drive home the point of valuation. Say a stock is currently trading at Rs. 100 in the stock market. You may feel that the price is fair and be compelled to buy it at that rate from the market. But, how do you know that the price at which the stock is quoting is what it is worth? For all you know, the stock could be worth more than Rs. 100, or it could also be worth much less than the current price.
The price of a stock trading in the exchanges is influenced by market sentiment and the forces of demand and supply. Therefore, even a stock with very good fundamentals might trade at a price that’s much lower than what it is actually worth. Valuation helps you identify such instances. And eventually, when price correction occurs, the market value of a stock gets closer to its actual, intrinsic worth.
Now that you’ve gotten a good grasp on valuation, let’s take a brief look at how to get to the valuation stage.
How to get to the valuation stage?
Arbitrarily conducting a valuation exercise will hardly get you anywhere. In fact, you would only be wasting your time and energy. So, before you get to the valuation stage, it is important to carry out an extensive fundamental analysis exercise. This is to effectively make sure that the company is backed by strong financials and offers good future growth prospects. Here’s a preview of the process flow that you should follow to get to the valuation stage.
- Choose the company whose fundamentals you would like to analyse.
- Read through its most recent annual report with an increased focus on its financial performance.
- Read and analyse its profit and loss statement, its balance sheet, and cash flow statement.
- Calculate the key ratios.
Once you’ve carried out this process, you should then set out to check if the company satisfies your expectations and conditions. If the company successfully manages to satisfy your expectations, you can then move on to the next stage, which is valuation. Otherwise, it’s a good idea to choose another company and start the process all over again.
Why is valuation important?
You’ve already seen one of the advantages that valuation offers - the ability to determine whether a stock is overvalued or undervalued. Let’s take a quick look at some of the other advantages that stock valuation gives investors like you.
It helps you identify the risk factors of a company
Valuation methods like the DCF stock valuation method take a company’s debt and expenses into consideration for calculating the free cash flows of the company. This exercise helps you identify the risk factors of a company, if any, by bringing to your notice glaring issues such as high debt or low liquidity.
It doesn’t take the current market price into consideration
Many valuation techniques completely disregard the market price at which a company’s shares trade. This allows you to get a more objective view of the company’s stock, since the only factors that you will consider for your calculations are completely fundamental and not related to the market movements or demand and supply at all.
It enables comparative evaluation of companies
The techniques used for valuation of a stock are standardised and utilise the same formulas. So, once you arrive at a result using these techniques, you can compare it with those of the company’s competitors. Such relevant comparisons allow you to make informed investment decisions.
In the forthcoming chapters of this module, we’ll be looking at the various valuation methods that you can employ, with an increased focus on the Discounted Cash Flow (DCF) stock valuation method. To be able to better understand these methods of valuation, it is essential for you to know about and appreciate the concept of time value of money. And that’s exactly what we’ll be learning about in the following segment.
The time value of money
The concept of time value of money is at the core of almost all valuation models. Let’s take up an example to better understand this concept.
Say you go to the market today to buy a kilo of apples. The shopkeeper quotes you a price of Rs. 75. Around the same time next year, you again go to the market to buy yourself a kilo of fresh apples. You take Rs. 75 with you, since that’s the price you paid for a kilo of apples the last time you went there. However, this time, the shopkeeper quotes you a price of Rs. 100 for a kilo of apples. But, he’s willing to give you 3/4th of a kilo for Rs. 75.
So basically, today, you were able to get 1 kilo of apples for Rs. 75, but at the same time next year, you would only be able to purchase 3/4th of a kilo with the same amount of money. What do you infer from this situation? Actually, there are two things:
- Compared to today, the value of money or the purchasing power of money in the future would be lower.
- The Rs. 100 that you get to make in the next year would be worth only Rs. 75 today.
Time value of money is a concept that explains why the value of money in the future is worth less today. The Discounted Cash Flow (DCF) method of valuation works on this specific principle. That’s primarily why this specific valuation method converts or ‘discounts’ the forecasted future earnings of a company to its present value (PV).
Understanding the concept of time value of money is quite easy. In the next chapter, you will get to see how future cash inflows are discounted to arrive at the present value, along with what the DCF valuation model is. As always, stay tuned and keep reading Smart Money!
A quick recap
- The main purpose or end result of fundamental analysis doesn’t just stop with helping you pick the right stocks.
- It is to help you make an objective assessment of whether the stock that you’ve picked is worth the price that it is currently trading at.
- The price of a stock trading in the exchanges is influenced by market sentiment and the forces of demand and supply.
- Therefore, even a stock with very good fundamentals might trade at a price that’s much lower than what it is actually worth. Valuation helps you identify such instances.
- Valuation is important because it helps identify the risk factors associated with a company and enables comparative evaluation of companies.
- The time value of money is an important concept related to valuation. It indicates that the value of money in the future is worth less today.