Valuation of shares before buying them is one of the biggest problems that beginners face because they are not familiar with the three main valuation methods that are available to them.
So in this blog post and video, I am going to introduce you to those 3 main valuation methods and explain how you can use them to value any business or company and thus its shares.
Method #1 – Net Asset Valuation
Also known as the “Sum of the Parts” model, the Net Asset Valuation method involves calculating what all the assets and liabilities of a business are worth and then adding them all up to reach a total.
Assets include buildings, machinery, equipment, inventory, cash, investments and so on – things that the business owns and could sell to someone else.
Liabilities include bank loans, leasing arrangements and goods which the company has bought but not yet paid for i.e. things that the business owes to someone else.
If you were buying the business outright, you would value the company assets and liabilities individually using a process known as due diligence.
As share investors, this method is not available to us so we need to get the summary values from the company’s Balance Sheet.
What is a Balance Sheet?
The Balance Sheet lists all of the company assets and liabilities and the value that the company believes they are worth (the book value) at the time the Balance Sheet was produced.
The Balance Sheet is a key document within every set of accounts and so is available to investors in the half-year (interim) and full-year (final) results.
To make it even easier for us, the Net Asset Value (NAV) of a company is usually calculated for us and shown as a separate line in the Balance Sheet.
Having got the Net Asset Value for the company, we then divide this by the total number of shares issued by the company to arrive at the net asset value per share or book value per share.
This therefore tells us how much each share of the company is worth in terms of its assets and liabilities.
We can then compare this with the current actual share price to decide whether the shares are overvalued or undervalued by the stock market.
Method #2 – Price to Earnings Comparison
With this method, we take the annual Earnings (otherwise known as Profits) of the company and multiply by the number of years of earnings we think the company is worth.
The best way to get this multiplication factor (the multiple) is to compare against the Price to Earnings (P/E) Ratios of similar companies on the stock market to find out what typical companies of this kind have as a P/E Ratio.
We then adjust this P/E multiple for our company, if required, to reflect the future prospects of the company we want to value compared with those of the reference companies we are using.
This method is extremely easy to use for shares because the multiple is exactly the same as dividing the Share Price by the Earnings Per Share (EPS) figure.
Indeed, the PE Ratio is commonly called the multiple for this very reason.
The EPS figure is widely available for companies already on the stock market and so, having got the EPS, just multiply it by the PE multiple that you think this company should have and you will arrive at the appropriate evaluation for the shares.
Comparing the actual share price with your calculated share price will tell you whether the market is currently overvaluing or undervaluing the company’s shares.
For real examples of how to do this, you can read some of the posts in my 2011 Performance mini-series.
Method #3 – Discounted Cash Flow Method (DCF)
This is the most complicated method of the three, by far, and it is not necessarily any more accurate.
It involves calculating Free Cash Flows of future years when a business is growing and a Terminal Value of the business when it has reached its steady state, usually assumed to be in 10-15 years time for a fast growing company.
As you can appreciate, that is a lot of complicated financial calculations and assumptions just to get those annual figures.
And that’s not the end of it!
Because we then need to turn those figures into Net Present Values (NPV) by discounting them back to today’s value of money using an assumed Cost of Capital.
This is a complicated activity in itself and I can’t do it justice in the small space here so I’m not even going to try!
Suffice it to say that this is the method that the stock market analysts and professional investors use but it is not a method that I would suggest beginners use unless you are an accountant.
So which valuation method is best for you?
Which Valuation Method Is Best?
All three methods have their benefits and drawbacks – no single method is best for everything.
The best one to use for your company/shares will depend on what kind of company it is.
For asset rich businesses like property firms, the Net Asset Value method is the most useful.
For companies with few assets, the P/E ratio comparison method is widely used.
The DCF method is best used by professional investors when buying high growth companies or those with predictable cash flows.
I spent (and wasted) a lot of time learning how to use the DCF method when I started investing in shares but I discovered that it was more a case of paralysis by analysis!
Which of these valuation methods have you tried for the valuation of shares? Leave me a comment below together with any questions if you have them.