At the end of these 700 words you will all be able to value your business, your shares, your investment property, even your spouse.

Doing the sums is is easy, but it's still a value judgment
December 11, 2010

YOU may have heard of a discounted cash-flow valuation. You should have. It is core to life, the financial industry and everything else. But, of course, half of us haven't and the other half are too afraid to ask.

So in a mild attempt to educate you, let me take you gently through it so you'll never have to nod cluelessly again. At the end of these 700 words you will all be able to value your business, your shares, your investment property, even your spouse.

Let's start with this. What is the value of a dollar? Well it's a dollar, of course. OK. So what is the value of a dollar in a year's time? Ah, well, it's not a dollar. And this is the issue. Thanks to inflation, a dollar in a year's time is only worth about 97¢ because, by the time you get the dollar, prices will have gone up by about 3 per cent, so the dollar in a year's time will only buy you about 97¢ worth of the goods that you could buy today.

We can now use this to value a company, an asset or an individual. All you have to do is work out how much money they are going to earn and, using inflation, turn those future dollars back into today's money, add them all up, add in the value of any other assets they have and that's what they are worth.

Here's the root calculation: A dollar earned in a year's time is worth $1 divided by 1.03 (1 plus the inflation rate). That's 97¢ in today's money (97.08¢, actually). To work out the current value of a dollar earned in two years you divide by 1.03 and divide by 1.03 again. Which gives us 94.26¢. So 94.26¢ is all you would want to pay for a dollar someone is going to give you in two years' time. So to bust a bit of jargon, the net present value (NPV) of a dollar earned in two years' time, discounted at the rate of inflation, is 94.26¢.

So now let's value a company. 

• Step one: Forecast how much profit it will make each year between now and eternity. 
• Step two: Use our calculation to ''discount'' all those future profits and price them in today's money. 
• Step three: Add up all those discounted profits. 
• Step four: Add any other assets (cash and buildings). That's the current value of the company and what someone buying the company should be prepared to pay today.

So you can see that by forecasting future profits and discounting the value of future profits back to today's money you can value almost any income-producing company, asset, property, or person. You can even work out what your own net present value is. If you spend more than you earn, it's zero.

So this is what research analysts do with shares. They forecast profits, discount those profits back to today's money, add them all up, account for any other assets, divide by the number of shares on issue and come up with what a share is worth. A lot of them call that a ''target price''.

Of course, it's not quite this simple. In the real world they don't use inflation. They calculate a ''discount rate'' and the arguments over what discount rate to use are endless, but basically, rather than inflation, it is what you could have earned investing your money somewhere else. It is the opportunity lost, not the inflation cost. So if you could have put the money in a bond for 10 years and earned 5.5 per cent you'd use that instead of inflation.

So that's it. How to value a company or share. Nice concept.

But before you go out and value your spouse you should know that it's all complete bollocks. Of course it is. Because, in the end, there are so many forecasts, assumptions and subjective opinions integrated into the calculation of value that it ceases to be a science and ends up an imperfect art. A basis for the negotiation of price at best. A starting point for an argument between buyer and seller. May the best negotiator win. And that's the sharemarket.

Marcus Padley is a stockbroker with Patersons Securities and the author of sharemarket newsletter Marcus Today. For a free trial visit marcustoday. com.au

His views do not necessarily reflect the views of Patersons.


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