Question

“My Lord a Valuation is not the Valuation’

The above sentence was made by an astute valuer who was defending his values in a court. The Judge and all the learned in the courtroom were baffled and astonished. After 30min of elucidating on the statement, the entire court cannot but applauded the Valuer. The Judge concluded “you Valuers are really friend who are learned”.

As a promising Valuer in the making, critically examine the statement, with examples and illustrations convince a client why a Valuation is not the Valuation.

(Word limit: 700 words)

Answer 1

Valuation is the process of determining the value of an asset. There are many approaches and estimating the inputs for a valuation model can be quite challenging. Investment success, however, can depend crucially on the analyst's ability to determine the values of securities/asset/companies.

Different types of values are:

> Market Value:

When a security trades on an exchange, buyers and sellers determine the market value of a stock or bond.

The market value of a stock or bond is the price value determined by market forces, for a security traded on the exchange.

> Fair Value:

A valuation can be useful when trying to determine the fair value of a security, which is determined by what a buyer is willing to pay a seller, assuming both parties enter the transaction willingly.

> Intrinsic Value:

The concept of intrinsic value, however, refers to the perceived value of a security based on future earnings or some other company attribute unrelated to the market price of a security.

To calculate value we have different models such as:

Absolute Valuation:

Absolute valuation models attempt to find the intrinsic or "true" value of an investment based only on fundamentals. Looking at fundamentals simply means you would only focus on such things as dividends, cash flow, and the growth rate for a single company, and not worry about any other companies. Valuation models that fall into this category include the dividend discount model, discounted cash flow model, residual income model, and asset-based model.

Relative Valuation:

Relative valuation models, in contrast, operate by comparing the company in question to other similar companies. These methods involve calculating multiples and ratios, such as the price-to-earnings multiple, and comparing them to the multiples of similar companies.

Comparable Company Analysis:

The comparable company analysis is a method that looks at similar companies, in size and industry, and how they trade to determine a fair value for a company or asset. The past transaction method looks at past transactions of similar companies to determine an appropriate value. There's also the asset-based valuation method, which adds up all the company's asset values, assuming they were sold at fair market value, and to get the intrinsic value.

An analyst can use any of the above models to determine the value of the asset/security to determine what are the factors which are important to him and take them into account while calculating the value.

Thus, what is important to one analyst may or may not be the same for other analysts:

Lets assume the case of 2 different analysts viz analyst A and analyst B trying to value company X with the following details/fundamentals
No. of equity shares = 100k, Risk free rate = 3%
Mkt value of debt = 1 million
Dividend per share (p.y) = $ 1.25
Price of share of company X = $ 6

Analyst A assumes
The growth rate of the dividend(g) = 5%
Risk of the company (beta) = 1.2
Market risk premium = 4%

so ,
K_e = R_f + * (R_m)

       = 0.03+ 1.2 * (0.04)

       = 0.03 + 0.048 = 0.078

      = 7.8%

Using single stage DDM
V₀ = d_{0 *} (1+g) / (K_e-g)

= 1.25*(1+0.05)/(0.078-0.05)

= $ 46.875 per share

Therefore value of X’ equity = value per share * no of shares

        46.875 * 100,000

Value of the company = market value of debt + Value of equity

= 1mn+4.6875mn

= $5.6875mn

Analyst B assumes
The growth rate of the dividend(g) = 4%
Risk of the company (beta) = 1.3
Market risk premium = 5%

so ,
K_e= R_f + *(R_m)

       = 0.03+1.3*(0.05)

       = 0.03+0.06

      = 9%

Using single stage DDM
V₀= d₀(1+g)/(ke-g)

               = $1.25(1+0.05)/(0.09-0.04)

= $26 per share

Therefore value of X equity = value per share * no of shares

        26*100,000

Value = market value of debt+Value of equity

= 1mn+2.6mn

= $3.6mn

So in the above illustration, we can see that by simply having different outlooks on growth and risk of the company, the analysts came to values which are far apart, while being “correct” they are different and neither can be called THE valuation.