## Thursday, 26 November 2015

### Valuation methods

Even the best investing strategies won't help you if you don't understand the value of the investments you are making.

Without assessing the future potential of your investments, you are simply gambling by letting probability take over.

It is in the nature of investment valuation that the calculations of their value are mathematical.

Return on Investment (ROI)

This is the end result of how much money you make or lose on an investment.

ROI = (P - C) / C

P= current market price at which you sold the investment
C = cost of the investment - the price you paid for it.

Present Value

Present value is the value that an investment with known future value has at the present time.

PV = FV / [(1+r)^t]

FV= amount of money you will receive at the end of the investment's life
r= the rate of return you are earning on the investment during that time
t= the amount of time that passes (in years) between now and the end of the investment's life.

This is an extremely common calculation with bonds, since bonds are sold at the discounted rate (the present value), and you must estimate whether the market price of the bond is above or below the present value to determine whether the price is worth it.

Net Present Value (NPV)

Net present value is the sum of present values on an investment that generates multiple cash flows.

When calculating NPV, calculate the present values of each payment you will receive, and then add them together.

ABSOLUTE AND RELATIVE MODELS

The value of fixed-rate investments is easy because you have certainty regarding what you will earn.

The problems come when you start estimating the value of variable-rate investments, like stocks or derivatives.

There are many complicated methods of calculating variable-rate investments, but they fall into three categories:

Absolute
Relative, and
Hybrid

Absolute models

Liquidation value or intrinsic value

Absolute models are the most popular among investors who look for the intrinsic value of an investment, rather than attempting to benefit by trading on movements in the market.

Such models include calculations of the liquidation value of the company, often adjusted for growth over the next few years.

In other words, you start with what the company would be worth if you simply sold everything it has for the cash, then subtract the debt.

Of course, the value of companies changes over time, and the market price of stocks is often based on the future earning potential of the company, rather than its current earnings.

So, estimates of liquidation value start with the current liquidation value and then increase that value by a percentage consistent with their average past growth, or by some other estimate of their future growth.

Dividend Discount Model  (DDM)

For investors who prefer investments that yield dividends, the DDM is popular.

DDM is calculated by working out the NPV of future dividends.

If you estimate that dividends will grow over that period, simply subtract the growth rate from the rate of return in the NPV calculation.

NPV = Dividend / (R - g)

R= discount rate
g= growth rate

For dividend investors, if the NPV of the dividends is lower than the current market price per share of the stock, the stock is undervalued, making it a great deal.

Relative Models

Relative models are popular among traders, who invest based on short-term movements in the market because they allow them to compare the performance of various options.

Common tools in performing these comparative assessments use the financial statements of a company and include:

Price to earnings ratio (P/E)

This functions as an indicator of the price you are paying for the profits a company will earn for you, either as dividends or through the investment of retained earnings.

Return on equity (ROE) = Net Income / Shareholder Equity

This indicates the amount of money a company makes using the money shareholders have invested in the company.

Operating margin = Operating Income / Net Sales

This indicates how efficiently a company is operating.

These indicators are not calculations of company value, but indicators of the comparative performance of companies in which one might invest.

Hybrids

Absolute and relative models are combined to create hybrids that attempt to estimate the value of a stock by combining the intrinsic value of the company with how well it performs compared to other potential investments.