Question

In valuation analysis, a company with certain fundamental operating characteristics will receive a higher valuation from investors than will a company that lacks them. What are four of these operating and/or financial performance characteristics?

Answer 1

Valuation analysis of a company by investors

Valuation analysis is a process to estimate the approximate value or worth of an asset, whether it’s a business, equity, fixed income security, commodity, real estate, or other assets. The value of an asset is basically the present value (PV) of all future cash flows that the asset is forecasted to produce.
There is no one model of valuation for different companies belonging to different industries. A valuation for a manufacturing company may be analysed from a multi-year discounted cash flow (DCF) model, whereas a real estate company would be best modeled with current net operating income (NOI) and capitalization rate (cap rate). Meanwhile, commodities such as iron ore, copper, or silver would be subject to a model centered around global supply and demand forecasts.

The output of valuation analysis can take many forms. It can be a single number, such as a company having a valuation of approximately $5 billion, or it could be a range of numbers if the value of an asset is largely dependent on a variable that often fluctuates, such as a corporate bond with a high duration having a valuation range between par and 90% of par depending on the yield on the 30-year Treasury bond.

Valuation analysis is important for investors to estimate intrinsic values of company shares in order to make better-informed investment decisions. Valuation analysis is a useful tool for comparing companies within the same sector or estimating a return on an investment over a given time period.

Valuation is the technique to determine the true worth of the stock after taking into account several parameters and then understand if the company is overvalued, undervalued or at par.

Factors affecting valuation of a company :-

1) Earnings: The earning of the company should also be analyzed along with the sales level. The income of the company is generated through the operating (in service industry like banks- interest on loans and investment) and non-operating income (rentals from lease, dividends from securities). The investor should analyze the sources of income properly. The investor should be well aware with the fact that the earnings of the company may vary due to following reasons:

• Change in sales.
• Change in costs.
• Depreciation method adopted.
• Inventory accounting method.
• Wages, salaries and fringe benefits.
• Income tax and other taxes.

Earnings Estimates

The estimated EPS is used by the investor to value the stock. Current stock price is a function of the price earnings ratio (P/E) and the future earnings estimate.

P/E Ratio

The price earnings ratio is very important consideration in doing company analysis. The P/E ratio shows how much of per dollar earnings investors presently are volitionally to pay for a stock. The market’s summary evaluation of the prospects of the company is reflected by P/E ratio.

Determinants of P/E Ratio:- Conceptually the price earnings ratio (P/E) is a function of three factors :-

P/E = D1/E1            

           k – g

Where k = required rate of return for stock

g = Expected growth rate in dividends

D1/E1 = expected dividend payout ratio

These three factors and their likely changes should be considered by the investors who are trying to determine the P/E ratio that will prevail for certain stock.

• The higher expected payout ratio indicates the higher the P/E ratio provided other things being equal. The expected growth rate in earnings & dividends (g) will likely decline if the payout ratio rises. This will severely affect P/E ratio. The reason for this decline is the availability of the lesser funds for the purpose of reinvestment in the company.
• There is inverse relationship between k and P/E ratio. The increased k will reduce the P/E ratio and similarly decrease in the k will enhance the P/E ratio provided other things being equal. The reason behind this is that required rate of return is the discount rate. Discount rates and P/E ratio moves inversely to each other.
• g and P/E are directly related. The increase in the g will enhance the P/E ratio provided other things being equal.

2) Capital Structure: Capital structure is combination of owned capital and debt capital which enables to maximize the value of the firm. Under this, we determine the proportion in which the capital should be raised from the different securities. The capital structure decisions are related with the mutual proportion of the long term sources of capital. The owned capital includes share capital.

3) Operationg efficiency :- Corporate governance describes the policies foolowed by an organization denoting the relationships and responsibilities between management, directors and stakeholders. These policies are defined and determined in the company charter and its bylaws, along with corporate laws and regulations. The purpose of corporate governance policies is to ensure that proper checks and balances are in place, making it more difficult for anyone to conduct unethical and illegal activities.

Good corporate governance is a situation in which a company complies with all of its governance policies and applicable government regulations in order protect the interests of the company's investors and other stakeholders.

Corporate governance policies typically cover a few following general areas:-

Financial and Information Transparency
This aspect of governance relates to the quality and timeliness of a company's financial disclosures and operational happenings. Sufficient transparency implies that a company's financial releases are written in a manner that stakeholders can follow what management is doing and therefore have a clear understanding of the company's current financial situation.

Stakeholder Rights
This aspect of corporate governance examines the extent that a company's policies are benefiting stakeholder interests. Companies with good governance give shareholders a certain amount of ownership voting rights to call meetings to discuss various issues with the board.

Another relevant area for good governance, in terms of ownership rights, is whether or not a company possesses large amounts of takeover defenses (such as the Macaroni Defense or the Poison Pill).

Structure of the Board of Directors
The board of directors is composed of representatives from the company and representatives from outside of the company. The combination of inside and outside directors attempts to provide an independent assessment of management's performance, making sure that the interests of shareholders are represented.

4) Analyzing Profitability of a Company :- Profitability ratios offer several different measures of the success of the firm at generating profits.
There are many factors that collectively provide basis for determining the EPS in the company. Key financial ratios are considered to examine these determining factors. The increasing or decreasing profitability of a company is ascertained by examining the components of the EPS.

EPS = ROE x Book Value per Share

Where book value per share is the accounting value of equity of shareholders on the basis of per share and ROE is the return on equity. Book value changes slowly so ROE is the main variable that should be focused upon.

EPS = Net Income after Taxes / Outstanding Shares

Book Value per Share = Shareholder’s Equity / Outstanding Shares

ROE = Net Income after Taxes / Stockholder’s Equity

ROE reflects the accounting rate of return that stockholders earn on their part of the entire capital employed to finance the company. The accounting value of the stockholder’s equity is measured by the book value per share.

Analyzing Return on Equity (ROE)

ROE = ROA x Leverage Leverage = Total Assets / Stockholder’s Equity

ROA is an important component of return on investment (ROE) and is used to measure the profitability of a company. ROE measures the return to stockholders while ROA measures the return on assets. The effects of leverage must be considered while going from ROA to ROE.
The measure of how a company fiance its assets, is referred to as leverage ratio. The company can either take debt or utilize only equity for financing its assets. The debt is although cheaper but more risky due to the associated regular interest payments which must be paid consistently from preventing bankruptcy. The returns to shareholders are either magnified with leverage or diminish with it. By the judicious use of debt financing, certain ROA can be magnified into higher ROE. On the other hand ROE is lowered than ROA by the injudicious use of Debt.