Business value cannot be precisely determined. Make use of ranges of values.

Business value cannot be precisely determined. 

Not only do a number of assumptions go into a business valuation, but relevant macro and micro economic factors are constantly changing, making a precise valuation impossible. 

Although anyone with a calculator or a spreadsheet can calculate a net present value of future cash flows, the precise values calculated are only as accurate as the underlying assumptions.

Investors should instead make use of ranges of values, and in some cases, of applying a base value. 

Ben Graham wrote:

The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate—e.g., to pro­tect a bond or to justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.

There are only three ways to value a business. 

1.   The first method involves finding the net present value by discounting future cash flows. 

Problems with this method involve trying to predict future cash flows, and determining a discount rate. 

Investors should err on the side of conservatism in making assumptions for use in net present value calculations, and even then a margin of safety should be applied.

2.  The second method is Private Market Value using Multiples. 

This is a multiples approach (e.g. P/E, EV/Sales) based on what business people have paid to acquire whole companies of a similar nature. 

The problems with this method are that comparables assume businesses are all equal, which they are not. 

Furthermore, exuberance can cause business people to make silly decisions. 

Therefore, basing your price on a price based on irrationality can lead to disaster. 

This is believed to be the least useful of the three valuation methods.

3.  Finally, liquidation value as a method of valuation. 

A distinction must be made between a company undergoing a fire sale (i.e. it needs to liquidate immediately to pay debts) and one that can liquidate over time. 

Fixed assets can be difficult to value, as some thought must be given to how customised the assets are (e.g. downtown real-estate is easily sold, mining equipment may not be).

When should each method be employed? 

They can all be used simultaneously to triangulate towards a value. 

In some cases, however, one might place more confidence in one method over the others. 

For example, 

• liquidation value would be more useful for a company with losses that trades below book value, while 
• net present value is more useful for a company with stable cash flows.

Using the methods of valuation described, you can search for stocks that are trading at a severe discount; it is possible, their stock price more than doubled soon after.

Beware of these failures

The failures of relying on a company's earnings per share - too easily massaged.

The failure of relying on a company's book value  - not necessarily relevant to today's value.

The failure of relying on a company's dividend yield - incentives of management to make yields appear attractive at the expense of the company's future.

Read also:

• 
  
• Your investments using Mutual Funds or Money Managers
• Trading and portfolio management from a value investing point of view
• Value Investor's Opportunities in Distressed Securities
• Value Investing Opportunities in the Banking Sector
• Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions
• Where to look for Investment Opportunities
• Business value cannot be precisely determined. Make use of ranges of values
• Central elements to a Value Investing Philosophy
• The Philosophy of Value Investing and Why It Works
• Philosophy of value investing. Need to have clear strategies too
• How Wall Streets can create investment fads? The Junk Bond Market of mid-1980s
• Understanding these changes in the investment world allows investors to earn superior returns
• What's good for Wall Street is not necessarily good for investors
• Speculators, Investors and Market Fluctuations

PE multiple is rooted in discounting theory

Valuation using multiples has its fundamentals rooted in discounting.  It is a shortcut to valuation.

In this method, all factors considered in a general DCF including cost of capital and growth rates are compressed in one figure, namely the multiple figure.  Multiples are also market-based.


Let's look at PE in detail.

PE =  Price / Earnings

Price
= PE x Earnings
= Earnings / (1/PE)


Compare this with the time-value of money equation:

PV = FV / (1+r)^n

or the dividend growth model:

PV = Div1 / (r-g)


Thus a PE multiple of 5 should nearly imply a discount rate of 20%.

The same goes for other kinds of multiples used in the financial markets:
EV/EBITDA multiples
EV/Sales
Price/Cash flow.

They are all short cuts for discounting.  The EBITDA, Sales and Cash flows are all proxies of the free cash flow.

DEFINITION OF 'DISCOUNTED CASH FLOW - DCF'

A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

Calculated as:

Also known as the Discounted Cash Flows Model.

Reference:  Finance for Beginners  by Hafeez Kamaruzzaman

Introduction to Valuation - Videos

Valuation is the process of determining what something is worth. It is arguably the most important, and most difficult thing we do in finance.

This gives an introductory look at valuation from Discounted CashFlow Analysis (DCF) to market multiples (comparables).