Tuesday, June 16, 2009

My dear, do you know how much I ‘value’ you

This intro article on valuation was long due from me. Every time I wanted to write the article, I had something or the other coming up my way and could not take this up..Anyways here it comes finally..

Valuation is like a torch in the dark: Assume you ought to purchase a house …You obviously need to have some base price in mind for that house. How do you derive the price for the house? You tend to think in terms of how much of a rental income this house can garner. You will also add in factors like whether the house is centrally located, whether there are any legal risks associated with the house, do we have water facilities associated with the house etc. So using these factors you might be able to roughly quantify the value of the house. So similar to quantifying the value of the house, the concept of Valuation in finance believes that every single asset can be ‘valued’. But take it with a tinge of caution …It is ‘roughly’.Hence if a Harvard MBA claims that he could value an asset precisely, may be ask him to repeat his course at Harvard!! Valuation involves a lot of uncertainties. In order to value a company, you have to be very comfortable with a particular company, the sector in which it operates, the key risks associated with the business. Hence more often than not it is not the person with significant hold on finance concepts emerges victorious on valuation but rather a person who is very comfortable with the business and the industry succeeds the most.

Keep your egos in check before a Valuation: Valuations are done based on discounted cash flow basis. Discounted cash flow is valuing the future cash flows of the company at the present value. This involves cash flow figure which is going to happen in the future, estimated growth rate for that cash flows, and the risk associated with receiving that cash flows...Man, Every data which has to be used is a future value. I always have the peculiar habit of trying to predict my CGPA half way through my semester. This is an activity which I have done right from my UG days...You know what…I have never come close to what my actual CG finally..There were a lot of factors which was leading to the difference. Either I would have gone terribly wrong in estimating my peers (The concept of Relative Grading) or my Professor would have set a unexpectedly difficult ‘Greek and Latin paper’ to me...Anything could have happened .But I confess I at least deviated 5-10% from my actual CG.But the good thing was I never stopped the habit of calculating it. It always gives me a sense of satisfaction to calculate it and come up with a number and it helped me in altering my preparation strategy for the rest of the semester. Valuation is also something similar …Microsoft beat the expectations of the analyst in 51 out of the 52 quarters during its high growth periods. They came up with a EPS of at least couple of cents above what the analysts predicted …But this did not stop the analysts from predicting the value next time …Valuation is a tool which would help you not to make some irrational decision...Assume CISCO wanted to acquire one of the growing technology companies...For sure the CISCO cannot come up with a 4th decimal digit accuracy of the target. But it helps CISCO in not paying a price way too much beyond the actual price. Hence don’t get upset or get too egoistic when you value a company as you are bound to go wrong.

Markets aren’t the best judge: If you are a believer in market efficiency, come out of the wrong notion that the markets predict the value of the equity of the firm correctly every time new information arrives. In fact market efficiency theory states that ‘New information comes into the market at random fashion and the markets adjust themselves to the information very rapidly” (not correctly).....Hence markets are also not correct every time and you have to be careful about the inefficiency in the market. And this existence of inefficiency in the market is what drives you and me to value the company and find its real worth and to earn abnormal profits out of that equity.

Hope the article threw some bit of insight about Valuations…..

PS: *Some of my critiques claim that my blog has less of technical content but has more of stories and other stuff embedded(like Bollywood , cricket etc) …My reasoning would be simple a) This blog is not to prove my technical prowess in finance . But rather it exists with the purpose of sharing the knowledge of corporate finance to as much people as I could...Currently my readers have been as diverse as my younger sister who has a little knowledge on corporate finance to some Profs, whose lectures have been the inspiration for my blog..Hence I have to take a balanced approach in my articles.

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