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.

Some Valuation Models are conservative, some are aggressive.

Friday, March 12, 2010

Valuation Models

A private equity player of my acquaintance once confessed that he had a basic rule of thumb about investments: double estimated expenses and halve projected future profits!


There are more systematic methods of valuation. Some valuation methods are themselves optimistic, others conservative. The multiples assigned to the valuation may also be conservative or optimistic. For example, the price to book value (PBV) ratio is a conservative valuation method. The underlying assumption: in bankruptcy, the investor will receive some portion of the original investment back. A cut-off PBV of 1 or less would be a conservative multiple.


But in an emerging market such as India with its high growth rates, a more optimistic PBV multiple can be assigned. In fact, if one examines average index PBV since 1991, the PBV has never dropped below 1.5.

A dividend yield-based valuation method is also conservative. It assumes no capital appreciation and treats the original investment like debt. Again, a high or low cut-off yield could be set depending on the risk-appetite.

Earnings growth-based valuations such as the PEG (Price-earnings to projected Earnings Growth) ratio are optimistic. A PEG valuation implies that a reliable projection of forward earnings and forward earnings growth is possible. A PEG multiple of less than 1 is conservative but the valuation method itself is optimistic.

Another, more conservative valuation method using earnings, is comparing earnings yield with the yield from a risk-free instrument. If the earnings yield is higher than the risk-free yield, the stock is worth investment. Again, conservative investors will keep greater margins of safety.

In a bull market, people give maximum weight to PEG ratios. In bear markets, more conservative methods come to the fore. At the peak of a business cycle, businesses will tend to be optimistically valued at high multiples. At the bottom, the same businesses will be available at low multiples.

In fact, historically, peaks and troughs in the same economy tend to be associated with similar levels of valuation. In India, bear market bottoms tend to be associated with conservative average multiples.  

• Usually the Nifty will be available at an earnings yield that is higher than the 364-day T-Bill yield. 
• The PEG will be well below 1. 
• The Price-book-value ratio will be down to less than 2.5 and 
• the Nifty's dividend yield will be over 2 per cent.

At the top of a bull market on the other hand, these multiples are all optimistic. 

• The PEG will be 1 or higher. 
• The earnings yield will be below the T-Bill yield. 
• The PBV will be higher than 4 and 
• the dividend yield will be below 1 per cent. 

Usually the PEG ratio is the last to go into the red zone by rising above 1. This is because the PEG is subjective and growth estimates tend to be optimistic during bull markets. There are minor variations but these average multiples have held good through the cycles of the last 15 years. This means that a conservative value-investor can buy when the multiples are in the bear-market range. And, it is time to sell when the multiples are in the range of a bull-market top.


Since January 2006, most of the valuation multiples have been high. However until late 2007, the PEG was below 1. It was only in early 2008 that the PEG rose beyond 1 and gave the final sell signal. By then, the market had already peaked.


The crash in October has pulled all the valuation multiples back close to the levels that would be expected at a bear market bottom. Right now, at a Nifty level of 2900, the PBV is at 2.42, while the dividend yield is 1.96 per cent and the PE ratio is 12.57, with an earnings yield of 7.9 per cent in comparison to the T-Bill yield of 7.4 per cent.


At the 2550 levels that prevailed for a while in late October, these multiples were even more attractive. The PEG ratio incidentally is close to 1. While the current PE ratios have dropped, so have the forward earnings growth estimates for 2008-09. But given the turmoil, there could be further EPS downgrades.


Is it worth buying into this market? Yes, it looks that way. Certainly systematic accumulation at these prices should work over the long-term.


This column appeared in the November 2008 Issue of Wealth Insight.

http://stockmakers.blogspot.com/2010/03/valuation-models.html