If you want to buy shares in a company then you will inevitably face the question of how much to pay for those shares.
To answer this question, you need to know how much the company’s shares are worth and to do that, you need to value them.
Once you have a valuation for the entire business or each share, you will then be in a position to decide whether the shares are currently available at a price that is above or below your valuation.
How To Value A Business
Of course, all this depends on your valuation of the business and how accurately you can value it.
Essentially, there are 3 key methods that you can use to value any business, company or its shares.
Watch this video to find out more:
Method #1 – Net Asset Valuation
Also known as the “Sum of the Parts” model, this 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’s assets and liabilities individually using a process known as due diligence.
As a share investor, 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’s assets and liabilities and the value that the company believes they are worth 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, we then divide this by the total number of shares issued by the company to arrive at the share price.
Method #2 – Price to Earnings Comparison
Generally speaking, this is the easiest and quickest way of valuing a business when you want to buy shares but it does have one or two things you need to consider when using it.
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 is to compare against the Price to Earnings (P/E) Ratios of similar companies on the stock market.
We then adjust this multiple, 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 obviously introduces an element of subjectivity into your valuation and relies on your skill, judgment and experience.
However, this method is extremely easy to use for buying 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 is a useful way of deciding whether a share is overvalued or undervalued.
For real examples of how to do this, you can read some of the posts in my 2012 Performance mini-series.
For more information on PE Ratios, read my earlier post here.
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.
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 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 when you want to buy 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 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.
How To Buy Shares
Now that you have your valuation for the shares you are considering buying, all you have to do is compare the current share price against this.
If they are priced below your valuation, they are undervalued and are a buy.
If they are priced above your valuation, they are overvalued and are a sell.
If they are priced about the same as your valuation, then they are a hold for those already owning the shares or a potential long-term buy.
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