There are billions of shares traded daily on stock exchanges across the world. Investors are seeking to either buy equity shares or a firm’s debt, however their primary concern is the amount they should pay for the shares or the debt. To determine the price to pay for a stock requires some form of valuation to be made. In this module, the valuation of securities will be explored, both in respect of how the initial valuation of a firm can be determined and how a fundamental investor can analyse this information for a more measured view.
Essentially, the value of a business is the combined value of the debt plus the value of the equity. There are many approaches that can be taken to value a business or an individual stock. The valuation methods explored in this module can be divided into two, namely: methods that do not involve forecasting and methods that do.
Methods that do not involve forecasting include: Comparables method, Multiple screening method and Asset-based valuations.
Comparables method is based on the view that similar businesses will have similar multiples. Examples of comparable methods include price to earnings ratios, price to book ratio and price to sales ratio.
Multiple screening method is an adaptation of the comparables method, but it uses screening to determine if a share is mispriced on the market.
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Asset-based valuation considers the value of the firm’s assets to determine its value and there are a variety of asset-based calculations that can be made.
Methods that involve forecasting are dividend models and discounted cash flow analysis. Dividend models can be used for valuation because they represent a return that investors get from their investment in the form of cash flows and therefore the investor can use the estimated return to calculate how much they may be willing to pay for the investment.
The discounted cashflow method uses the estimated future cash flows arising from the business to determine the value of the business. The method uses free cash which is the cashflow from operations effectively resulting from operations less the cash used to make investments.
Each method will give a different value for a business and it is up to the fundamental investor to look at all of these and balance the calculated values with further analysis of the business. This further analysis should consider all the other factors such as the current market conditions, the economic climate and the competition.
You will learn that each method has its own advantages and disadvantages but if the fundamental investor takes some account of these other factors then this will modify their view of the value; i.e. if the investor knows that the comparable companies are similar but not identical then some value can be added or deducted, metaphorically, when considering the investment to compensate for this.
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