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Valuation: Definition, Usage, Different Methods, Types, Calculation, Limitations          

Valuation: Definition, Usage, Different Methods, Types, Calculation, Limitations

Valuation: Definition, Usage, Different Methods, Types, Calculation, Limitations
By Arjun Arjun Remesh | Reviewed by Shivam Shivam Gaba | Updated on January 19, 2024

Stock valuation is the process of determining the intrinsic worth or fair market value of a company’s shares based on its financial performance, prospects and position relative to comparable companies. Stock valuation involves using analytical techniques to estimate key metrics like future cash flows, earnings, assets and growth potential that drive a company’s long-term value. 

There are approaches to Valuation, with the most common being discounted cash flow analysis, multiples-based methods including price-to-earnings and enterprise value to EBITDA, as well as asset- and dividend-based models. By making reasonable forecasts and applying an appropriate discount rate or Valuation multiple, an estimate can be derived for the per-share value of the company. 

This intrinsic Valuation is then compared to the current trading price in the stock market to identify potential undervalued or overvalued situations. Fundamental analysis of financial statements, industry dynamics, competitive positioning and management quality feeds into assumptions underpinning valuation models. A range of valuation methods applied prudently can help investors uncover quality companies trading at bargain levels relative to their true worth.

What is Valuation?

Valuation refers to the process of determining the current worth or price of a stock. Valuation looks at ratios like P/E as well as discounted cash flows to estimate the fair value of shares versus the current trading price. There are different valuation methods used by investors and analysts to estimate the intrinsic value of a company’s shares. The most common valuation techniques include discounted cash flow analysis, multiple-based Valuation, and asset-based Valuation. 

What are the usages of Valuation?

One of the main uses of Valuation is to inform investment decisions. Investors conduct valuation analysis to determine if a stock is underpriced or overpriced compared to its intrinsic value. This helps investors decide which stocks to buy, sell, or hold. Valuation provides an analytical framework for making more informed and calculated investment moves. Investors need to have a sense of a stock’s fair value to assess if it represents a good investment at the current price.

Fund managers and other professional investors use valuation methodologies to construct stock portfolios. Determining the fair value of securities is crucial for portfolio optimization and risk management. Overvalued stocks are cut from the portfolio to reduce risk. Undervalued stocks with upside potential are added to enhance returns. Ongoing Valuation of the holdings provides guidance for rebalancing the portfolio mix.

Valuation drives the pricing decisions in mergers, acquisitions, and other corporate transactions. Both the target company and the acquiring company will perform valuations to negotiate the deal terms. Independent valuations provide an objective estimate of the target’s enterprise value to facilitate the deal process in a merger context. Stock market indexes rely on valuation-based criteria to determine the basket of securities included. Stocks with valuations exceeding specified thresholds relative to earnings, cash flows, or book values sometimes qualify for inclusion in an index. Additionally, indexes apply valuation-based weighting schemes, so higher-valued companies have greater representation.

What are the methods available for Valuation?

The main methods used for valuing stocks include discounted cash flow analysis, relative Valuation approaches like price-to-earnings and price-to-book ratios, Valuation based on future growth assumptions, and asset-based valuations looking at the company’s tangible assets.

What are the methods available for valuation
Valuation: Definition, Usage, Different Methods, Types, Calculation, Limitations 4

1.Discounted cash flow method

The discounted cash flow (DCF) method values a stock by estimating the company’s future cash flows and discounting them back to the present value. The basic premise is that the fair value of a stock is equal to the discounted sum of all of its future free cash flows. 

The formula for DCF is as stated below.

Stock Value = CF1/(1+r) + CF2/(1+r)2 + CF3/(1+r)3 + … + CFt/(1+r)t

Where CF is the expected cash flow for each period, and r is the discount rate. For instance, the stock value of a firm with three years of forecast cash flows of Rs. 1 million, Rs. 1.5 million, and Rs. 2 million, and a 12% discount rate would be as follows.

Stock Value = Rs. 1,000,000/1.12 + Rs. 1,500,000/1.122 + Rs. 2,000,000/1.123 = Rs. 4,317,412

So, the DCF model requires estimates of future cash flows and an appropriate discount rate to calculate the present value of those cash flows as the fair stock value. It is a commonly used method for stock valuation.

2. Discounted dividend method

The discounted dividend model is a method used to value a stock based on the present value of its future dividend payments. It operates under the assumption that the value of a stock is equal to the sum of all of its future dividend payments, discounted back to its value today. 

The formula for the discounted dividend model is as stated below.

Stock Value = D1/(1+r) + D2/(1+r)2 + D3/(1+r)3 + … + Dn/(1+r)n

Where D1, D2, etc., are the expected dividend payments for each period, and r is the discount rate. For instance, the value would be computed as follows if a stock was predicted to pay dividends of Rs. 1, Rs. 1.10, and Rs. 1.21 over the following three years, and the discount rate was 5%.

Stock Value = Rs. 1/1.05 + Rs. 1.1/1.052 + Rs. 1.21/1.053 = Rs. 3.15

So, the discounted dividend model provides a way to calculate the fair value of a stock based on predictions of its future dividend payouts. The key inputs are the dividend forecasts and the discount rate.

3. Capital asset pricing method

The capital asset pricing model is used to calculate the expected return on an investment based on its risk level. According to CAPM, the expected return on an asset is equal to the risk-free return plus a risk premium, which is based on the asset’s beta. 

The formula for CAPM is as stated below.

Expected Return = Rf + β(Rm – Rf)

Where Rf is the risk-free rate, β is the asset’s beta, and Rm is the expected return of the market. For instance, the projected return would be as follows: if the market return was predicted to be 12%, the risk-free rate was 5%, and the beta was 1.2.

Expected Return = 0.05 + 1.2(0.12 – 0.05) = 0.134 or 13.4%

So, in this example, based on the risk level as measured by beta, the expected return on the investment is 13.4%. The CAPM provides a straightforward way to calculate expected returns based on systemic risk. It is a foundational model in asset pricing and stock valuation.

4. Guideline companies method

The guideline companies method values a stock by comparing it to similar publicly traded companies in the same industry. The goal is to derive a valuation multiple, such as a price-to-earnings (P/E) ratio, from comparable companies that are then applied to the stock being valued.

The formula is as follows.

Stock Value = Metrix Value x Comparable Company Multiple 

For example, assuming a stock has earnings per share of Rs. 2 and the average P/E ratio of comparable companies is 15x, the Valuation would be as given below.

Stock Value = Rs. 2 x 15 = Rs. 30

So, the stock would be valued at Rs. 30 per share based on applying the industry average P/E multiple. The key to this method is identifying relevant guideline companies that align closely with the company being valued. The derived multiples provide valuation benchmarks to estimate the stock’s potential worth. It is a commonly used approach when valuing IPOs and acquisitions.

5. Times revenue method

The time’s revenue method values a stock by multiplying the company’s revenue by an industry-average revenue multiple. The implied Valuation is based on how much revenue the company generates relative to its peers. 

The formula is as stated below.

Stock Value = Revenue x Multiple

For example, assuming a company has Rs. 50 million in revenue, and the industry average price-to-sales multiple is 5x; the Valuation would be as follows.

Stock Value = Rs. 50,000,000 x 5 = Rs. 250,000,000

So, the market capitalization value of the stock would be Rs. 250 million based on applying the 5x industry multiple to revenue. This method provides a straightforward benchmark for Valuation based on top-line revenues rather than bottom-line profits. However, the revenue multiples used vary widely across industries. The key is identifying reasonable comparable companies to derive an applicable multiple.

6. Asset-based method

The asset-based valuation method values a stock based on the company’s underlying net asset value rather than its earnings or revenues. The net asset value is the total asset base minus total liabilities. 

The formula is as stated below.

Stock Value = Net Assets 

For example, assuming a company has Rs. 100 million in total assets and Rs. 20 million in total liabilities, the net asset value would be Rs. 80 million. Applying the asset-based method, the market capitalization value of the stock would be the net asset value as given below.

Stock Value = Net Assets 

            = Total Assets – Total Liabilities

            = Rs. 100,000,000 – Rs. 20,000,000

            = Rs. 80,000,000

So, the stock would have a valuation of Rs. 80 million based on its net assets. This method evaluates the company’s balance sheet rather than the income statement. It is best suited for capital-intensive industries like manufacturing, railroads, and oil & gas.

7. Comparable company method

The comparable company method values a stock by analyzing the trading multiples of similar public companies. It derives valuation multiples like the price-to-earnings (P/E) ratio from comparable stocks in the same industry and applies them to the stock being valued.

The formula is as follows.

Stock Value = Selected Metric x Comparable Company Multiple

For example, assuming a stock has earnings per share of Rs. 2 and comparable companies in the industry trade at an average P/E of 15x, the Valuation would be as given below.

Stock Value = Rs. 2 x 15 = Rs. 30

So, the stock would be valued at Rs. 30 per share by applying the 15x industry average P/E multiple. The key to this method is identifying appropriate comparable companies that operate similar businesses. It provides a market-based valuation approach based on how the market values close peers. The derived multiples serve as benchmarks to estimate the potential stock value.

8. Market capitalization method

The market capitalization method values a company by multiplying its current share price by the Number of outstanding shares. Market cap indicates the total market value of a company’s equity. 

The formula is as stated below.

Market Capitalization = Share Price x Number of Shares Outstanding

For example, assuming a company has 100 million shares outstanding and its current share price is Rs. 50, the market capitalization would be as follows.

Market Capitalization = Rs. 50 x 100,000,000 = Rs. 5,000,000,000

So, this company would have a market capitalization of Rs. 5 billion based on its share price and shares outstanding. Comparing market caps helps determine the size and Valuation of a company relative to its peers. The market cap changes over time as the share price changes. This method provides a straightforward snapshot of a stock’s total market value based on current market pricing.

9. Enterprise value method

The enterprise value method determines the value of a whole company, including both equity and debt. Enterprise value provides a more comprehensive valuation than just looking at market capitalization alone.

The formula is as stated below.

Enterprise Value = Market Capitalization + Debt – Cash and Cash Equivalents

For example, assuming a company has a market cap of Rs. 2 billion, Rs. 500 million of debt, and Rs. 100 million in cash, the enterprise value would be as follows.

Enterprise Value = Rs. 2,000,000,000 + Rs. 500,000,000 – Rs. 100,000,000 = Rs. 2,400,000,000

So, the total enterprise value would be Rs. 2.4 billion, including the market cap as well as net debt. The EV method accounts for capital structure and additional assets & liabilities. Comparing enterprise values helps control for different debt levels when valuing stocks. It provides a more all-encompassing company valuation than simple market capitalization.

10. Earnings multiplier method

The earnings multiplier method values a stock by applying a multiple to the company’s earnings per share (EPS). The earnings multiple is derived from comparable public companies in the same industry to estimate an appropriate valuation multiple. 

The formula is as stated below.

Stock Value = EPS x Earnings Multiple

For example, assuming a company has an EPS of Rs. 2 and the average price-to-earnings multiple in the industry is 15x, the Valuation would be as follows.

Stock Value = Rs. 2 x 15 = Rs. 30

So, the stock would be valued at Rs. 30 per share by applying the 15x industry average earnings multiple. This method provides a market-based approach to Valuation using profitability metrics. The key is determining the appropriate earnings multiple based on multiples of comparable stocks. The derived multiple provides an earnings-based benchmark to estimate the stock’s potential value.

11. Book value method

The book value method values a stock based on the company’s book value, which is the difference between a company’s total assets and total liabilities, as stated on the balance sheet. It represents the company’s theoretical liquidation value after all debts are paid. 

The formula is simply as follows.

Book Value per Share = (Total Assets – Total Liabilities) / Number of Shares Outstanding

For example, assuming a company has Rs. 100 million in total assets, Rs. 80 million in total liabilities, and 10 million shares outstanding, the book value per share would be (Rs. 100 million – Rs. 80 million) / 10 million = Rs. 2 per share

The book value method assumes that assets are valued accurately and does not account for intangibles like brand value and growth potential. While easy to calculate, it does not always accurately represent the true value of a stock. The method is best used in conjunction with other valuation techniques like discounted cash flow analysis.

12. Liquidation method

The liquidation valuation method estimates the value of a stock based on the net amount that would be realized if the company terminated operations and sold all of its assets. It assumes all liabilities need to be paid off before shareholders receive any proceeds.

The formula is as stated below.

Liquidation value per share = (Liquidation value of assets – Liabilities) / Number of shares outstanding

For example, assuming a company has Rs. 500 million in asset value, Rs. 300 million in total liabilities, and 100 million shares outstanding, the liquidation value per share would be (Rs. 500 million – Rs. 300 million) / 100 million = Rs. 2 per share.

The liquidation method provides a conservative lower-bound estimate for stock valuation. However, it does not account for intangible assets and the full earnings potential of a continuing business. While useful in distressed situations, the liquidation value will generally be lower than the true economic value of a viable operating company. It is most relevant for companies facing bankruptcy or liquidation.

13. Contingent claim method

The contingent claim valuation method treats a stock as an option on the assets of a company. Similar to a call option, a stock gives the shareholder the right, but not the obligation, to buy the company’s assets at a future time for the strike price equal to the liabilities owed.  

The formula is based on the Black-Scholes option pricing model and is as follows.

Stock Price = Assets x (N(d1)) – Strike Price x exp(-rf) x (N(d2)) 

Where N(d1) and N(d2) represent the cumulative normal distribution function, rf is the risk-free rate, and other variables are calculated from asset value, strike price, volatility, and time to maturity.

For example, assuming a corporation has Rs. 10 million in assets, Rs. 5 million in liabilities, 20% volatility, 5 years to maturity, and a 5% risk-free rate, the Black-Scholes model predicts a stock price of Rs. 8.2 million.

The contingent claim method accounts for limited liability and optionality but requires complex option pricing models. It is not commonly used in practice but provides insight into how a stock’s value derives from the assets and liabilities of a firm.

14. Precedent transactions method

The precedent transactions method values a stock based on previous acquisition prices paid for similar companies in the industry. It assumes that rational buyers will not pay more than fair value for an acquisition target.

While there is no set formula, the approach considers valuation multiples like P/E, P/S, and P/B and applies them based on comparable transactions. An estimation of Valuation might be as follows: for instance, if the company’s revenue is Rs. 150 million and its competitors in the same sector were recently purchased for three times their revenue.

Precedent Transaction Value = Rs. 150 million revenue x 3 revenue multiple = Rs. 450 million

The precedent transactions method provides real market-based evidence of value. However, finding perfect “comparables” is difficult. Industries and companies differ widely in growth trajectories, risks, and competitive advantages. The method should be used as a data point to complement other valuation techniques like DCF analysis.

15. EBITDA method

The EBITDA valuation method values a stock based on the company’s EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortisation. It aims to estimate the core earning power of a business before accounting adjustments. 

The formula simply involves applying an EBITDA multiple.

Stock Value = EBITDA x Comparable Industry EBITDA Multiple 

For instance, the value would be as follows if a company’s EBITDA was Rs. 20 million and the industry average multiple was 10x.

Stock Value = Rs. 20 million EBITDA x 10 EBITDA multiple = Rs. 200 million

The EBITDA method is popular for valuing cash-flow-based businesses like infrastructure and real estate. However, it does not account for capital expenditures and other balance sheet considerations. The quality of the Valuation depends heavily on identifying the appropriate EBITDA multiple through precedent transactions and peer comparisons. Overall, it provides a straightforward approach to Valuation based on the operating profitability of a business.

There are numerous valuation methods available, each with its own advantages and limitations, but ultimately, the most accurate stock valuation requires thoughtfully applying a combination of approaches.

What are the types of valuation models?

The two main types of valuation models used in the stock market are absolute valuation models, which estimate the intrinsic value of a stock based on fundamentals, and relative valuation models, which determine the fair value of a stock compared to industry peers or the broader market.

  • Absolute Valuation Models

Absolute valuation models attempt to find the intrinsic or true value of a stock based on fundamentals. These models use analysis of financial metrics and ratios to determine if a stock is undervalued or overvalued. The most common absolute valuation models are the Discounted Cash Flow (DCF) Model, Dividend Discount Model, Asset-Based Valuation, and Liquidation Value Model.

Discounted Cash Flow (DCF) Model: This model estimates the intrinsic value of a stock by projecting its future cash flows and discounting them back to the present using the time value of money concept. Key inputs are the company’s projected free cash flows, discount rate, and terminal value. DCF models allow analysts to value a stock based on its expected future performance rather than just past results.

Dividend Discount Model: This model values a stock based on the present value of its expected future dividend payments. Analysts estimate the future dividends per share and apply an appropriate discount rate to calculate the present value. The dividend discount model is best suited for mature, stable companies with a consistent dividend history.

Asset-Based Valuation: This model values a company by estimating the market value of its assets net of liabilities. Book value or replacement value of assets are used. Asset-based models are applicable to capital-intensive industries like manufacturing, real estate, and oil & gas.

Liquidation Value Model: This model determines a company’s value based on the estimated amount that shareholders would receive if it were dissolved and liquidated. Liquidation value equals assets net of liabilities and liquidation costs. It assumes assets are sold individually, not as part of a going concern.

  • Relative Valuation Models 

Relative valuation models estimate the value of a stock by examining valuation metrics in comparison to other similar stocks. These models do not attempt to find the intrinsic value but rather the fair value relative to peers. Common relative valuation methods include the Price-to-Earnings (P/E) Ratio, Price-to-Book (P/B) Ratio, Enterprise Value (EV) to EBITDA, and Price-to-Sales Ratio.

Price-to-Earnings (P/E) Ratio: The P/E ratio measures the current share price relative to the company’s earnings per share. Comparing P/E ratios within an industry indicates whether a stock is undervalued or overvalued relative to peers.

Price-to-Book (P/B) Ratio: The P/B ratio compares the company’s current market capitalization to its book value. It helps identify relatively undervalued or overvalued stocks within an industry or sector.

Enterprise Value (EV) to EBITDA: This ratio compares a company’s enterprise value (market cap + debt – cash) to Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA). It allows comparisons of valuation multiples adjusting for capital structure differences between companies.

Price to Sales Ratio: This ratio measures the company’s market cap relative to its total revenues. It is used to value stocks with zero or negative earnings.

The main types of stock valuation models are absolute models like DCF, dividend discount, asset-based, and liquidation value, which estimate intrinsic value, and relative models like P/E, P/B, EV/EBITDA, and P/S, which determine fair value compared to similar companies; the appropriate model depends on the stock and industry characteristics.

How to calculate company valuation?

Company valuation is estimated by analyzing financial metrics like revenue, profitability, growth prospects, assets, and liabilities and comparing multiples like price-to-earnings and enterprise value-to-EBITDA ratios to similar publicly traded companies, with the goal of determining the potential market capitalization if the company were to go public. 

One valuation method is discounted cash flow (DCF) analysis. This estimates company value based on projected future cash flows discounted back to the present. For Infosys, the first step is to forecast near-term cash flows for the next 5 years based on revenue growth rates, operating margins, capital expenditures, depreciation, and changes in working capital. Revenue growth is estimated from past trends, market growth rates, and management guidance. Operating margins are projected based on historical levels and expected improvement.

After projecting near-term cash flows, a terminal value is determined to approximate the cash flows extending beyond the forecast period indefinitely. This terminal value hinges on the presumption of consistent long-term growth and steady profit margins. Subsequently, the anticipated cash flows are discounted to their present value using Infosys’s weighted average cost of capital (WACC), which incorporates the expected returns on both equity and debt, reflecting their associated risks. The DCF analysis aggregates these present values of the anticipated future cash flows, resulting in a business valuation ratio that is twice as comprehensive.

How to find the Valuation of a company?

The strike has all the information needed to find a company’s Valuation. The first step is to analyze the company’s financial statements, like the income statement, balance sheet, and cash flow statement. Next, common valuation methods are applied, like discounted cash flow analysis or comparing the company’s financial metrics to similar publicly traded companies. Finally, factors like future growth prospects, market conditions, and risks are considered to determine the overall Valuation of the private or public company.

How to do a valuation of a distressed company?

Valuing a distressed company for stock market purposes requires analyzing the company’s assets, liabilities, cash flows, and earnings potential. Look at the company’s balance sheet to estimate liquidation value based on assets that could be sold off. Estimate future cash flows under a potential turnaround situation based on projected revenues, costs, capital expenditures, etc. Apply valuation multiples like P/E and P/B ratios of comparable healthy companies to the distressed company’s metrics to estimate what the value could rise to if performance improves. Conduct discounted cash flow analysis to determine equity value based on projected future cash flows. The intrinsic value from these methodologies is compared to the company’s current stock price to evaluate whether shares are undervalued due to temporary distress and represent a potential investment opportunity.

How to do a valuation of a startup company?

Valuing early-stage startup companies for public markets is challenging due to a lack of financial history and uncertainty around future growth. Common approaches include comparable company analysis, precedent transaction analysis and discounted cash flow models. Compare revenue multiples, growth rates and profitability margins to similar publicly traded companies in the startup sector to estimate Valuation. Analyse valuation multiples paid in recent acquisitions of startups in the same domain.

Build DCF models forecasting financial performance for 5-10 years, applying assumptions on revenue growth, margins, capex, etc. Discount projected free cash flows to firms at an appropriate cost of capital to derive a valuation. Conduct scenario analysis using different growth/margin assumptions. The startup’s implied Valuation from these methodologies is benchmarked vs. recent private funding rounds. An IPO price would need to balance growth prospects with reasonable near-term upside for public investors.

How to do a valuation of intangible assets?

Valuing intangible assets like patents, trademarks, brand names, and goodwill is challenging for public market investors, as they lack physical substance and their worth is based on expected future economic benefits. Common valuation approaches include the cost method, which estimates the cost to develop the asset, and the income method, which projects income attributable to the intangible asset and discounts it to present value.

Market-based methods are also used, evaluating comparable licensing deals for similar intangible assets. For IP assets, experts sometimes use patent renewal data or citations to estimate value. Brand names are valued via price premium analysis or historical marketing costs. Goodwill is valued by subtracting the fair market value of identifiable assets from the overall purchase price. While intangibles lack tangible worth, analyzing their ability to generate revenues and growth for a company derives reasonable market value estimates for stock analysis.

What are the limitations of Valuation?

One major limitation of valuation techniques is that they rely heavily on estimates and assumptions. Valuation models require inputs like future cash flows, growth rates, and discount rates. These inputs are uncertain and based on guesses about the future rather than hard facts. Small changes in assumptions dramatically impact valuation outputs. Investors must use their judgement when choosing inputs and be aware of the sensitivity of Valuation to different assumptions. The timing of cash flows represents another limitation. Valuation models such as discounted cash flow analysis rely on projections of future cash flows. However, the timing of cash flows is difficult to predict. Revenue growth is slower or faster than expected. Major capital expenditures or changes in working capital requirements significantly impact cash flow timing. Valuation models struggle to accurately reflect cash flow timing, which affects valuation output.

Stocks are under or overvalued for prolonged periods. Valuation models try to estimate intrinsic value, but market prices sometimes deviate from intrinsic value for months or years. The famous saying that the market stays irrational longer than you stay solvent illustrates this limitation. Investors are unable to predict whether the difference between market price and intrinsic value will narrow, even in cases when Valuation indicates that a company is materially undervalued or overvalued. Different valuation methodologies make contradictory assumptions and produce vastly different results for the same company. Models like discounted cash flow analysis, dividend discount models and residual income models all use different frameworks for determining fair value. Furthermore, using the same model with different inputs results in divergent valuations. The subjectivity inherent in choosing valuation methods and inputs is a limitation for investors.

The applicability of valuation methods varies across industries. Capital-intensive, cyclical and commodity industries are harder to value than consumer product or software companies. Industries like biotech with long product development cycles are poorly suited to discounted cash flow analysis. No single valuation approach works equally well across all sectors, limiting inter-industry comparisons. Investors must understand how industry dynamics impact the relevance of valuation techniques.

How to minimize bias in Valuation?

Analysts should be aware of their own biases and institutional pressures that sometimes influence their assumptions and inputs. Being transparent about biases upfront, using valuation ranges rather than point estimates, and avoiding pre-commitments to a valuation conclusion help mitigate bias. Uncertainty is inherent in Valuation, especially for high-growth or emerging companies. Analysts should focus on making their best estimates for company-specific inputs while avoiding macroeconomic predictions. Using valuation models, sensitivity analysis, scenarios, and simulation quantify the uncertainty and provide useful insight despite imprecision. For investors, valuations with more uncertainty provide a greater edge relative to consensus. Ultimately, maintaining flexibility as new information arrives is key to managing bias and uncertainty in Valuation.

What is mismarking in Valuation?

Mismarking refers to the intentional manipulation of financial models or subjective adjustments of inputs in order to artificially increase or decrease a valuation. It is an unethical practice that distorts true value and misleads investors and stakeholders. Mismarking gained prominence in the 2008 financial crisis but continues to pose risks even today. There are five ways in which mismarking occurs in valuations: Adjusting Quantitative Models, Ignoring Red Flags, Opaque Adjustments, Last-Minute Changes, and Complex Models.

Valuation models rely on analyst estimates for inputs like revenue growth, margins, capital expenditure, etc. By tweaking these subjective inputs, the final Valuation is usually altered. For example, an analyst wanting to justify a higher price target uses an unrealistically high growth rate assumption.

What is the difference between pre-money vs post-money Valuation?

Pre-money Valuation refers to the value of a company before outside investment, while post-money Valuation accounts for the company’s value after outside capital is injected, thus increasing the total value. Post-money valuation refers to the total Valuation of a company after a new investment round closes, calculated by adding the new capital invested to the pre-money Valuation. As a company raises successive rounds, the post-money Valuation typically increases as milestones are met and risk decreases. Post-money valuation determines the ownership stake new investors receive and serves as the starting pre-money Valuation for the next round. During an acquisition, the post-money Valuation represents the total deal value inclusive of any premium paid by the acquirer.

On the other hand, pre-money Valuation represents the value of a company before a new investment, calculated by multiplying its existing outstanding shares by the current share price. It sets investor expectations, provides a baseline to determine ownership stakes, and establishes future fundraising potential. During an IPO, pre-money Valuation is based on the offer price rather than the existing share price. Pre-money Valuation is critical for early stage companies to avoid excessive dilution in follow-on rounds if set too high initially. Once public trading commences, the company’s Valuation becomes its market capitalization rather than pre-money value.

What is NIL valuation?

Nil valuation refers to a situation where a company’s stock has no value or is valued at zero. This happens for several reasons in the stock market. A company will have nil valuation if it goes bankrupt and is liquidated. A company’s assets are liquidated to pay creditors when it files for bankruptcy protection and is going through the liquidation process. Once this process is completed, there are no assets left in the company and hence, its stock becomes worthless. Investors lose the entire value of their investment as the stock price falls to zero. Several firms like Enron and WorldCom had nil valuations after high-profile bankruptcies in the early 2000s. Nil valuation occurs in cases of financial distress before a bankruptcy filing. Investors value a company’s shares at zero in the event that it is in serious financial trouble and is about to file for bankruptcy due to the strong likelihood that equity holders will lose everything. The company sometimes is bleeding cash, has high debt levels, and has limited prospects of turning around its business. This financial uncertainty leads investors to assign no value to its stocks.

What is a 409A valuation?

A 409A valuation is a company’s estimated fair market value that is used to determine the price of stock options and other equity compensation for tax purposes. It gets its name from Section 409A of the U.S. tax code, which governs deferred compensation arrangements like stock options. For most employees receiving stock options, the exercise price is simply the market price of the stock on the grant date. However, for executives and certain shareholders, tax rules require the exercise price to be the fair market value on the grant date. Otherwise, they are liable for a 20% excise tax plus penalty interest.

To determine fair market value and avoid this penalty tax, companies obtain an independent 409A valuation from a qualified third-party valuation firm. The valuation firm uses accepted methods like discounted cash flow, comparable transactions, and venture capital models to estimate the company’s fair value. This 409A valuation provides the minimum exercise price the company will be able to use for options granted to affected employees. The 409A valuation process is more rigorous than normal valuations. The valuation firm must use current financial data, interviews with management, and proprietary valuation models. The valuation report must also conform to IRS requirements to demonstrate due diligence. Often, companies get 409A valuations done annually to support ongoing option grants.

For private companies, the 409A Valuation provides an objective stock price benchmark since their stock does not trade on public exchanges. The Valuation aligns equity compensation with actual company value, ensuring employees do not receive artificially discounted options. It also reduces taxes for employees and deductions for employers.

How can fundamental analysis help in Valuation?

Fundamental analysis helps by examining a company’s financial statements like the balance sheet, income statement, and cash flow statement. By studying these statements over time, an analyst gauges the company’s financial health and performance. Metrics like revenue growth, profit margins, debt levels, and cash flows indicate how well a business is executing its strategy. Comparing financial ratios like P/E, P/B, and P/S ratios across industry peers also provides insight into relative Valuation.

The financial statements provide the raw data to model and value the stock. Analyzing the competitive landscape, economic conditions, and management team gives context for the financial performance. The analyst determines the company’s strengths, weaknesses, opportunities and threats. This SWOT analysis reveals the qualitative factors impacting the business. Understanding the macroeconomic environment and industry trends is also key.

Fundamental analysis aims to separate well-run, high-quality companies from poorly-run, low-quality companies. The former warrants a valuation premium, while the latter is sometimes riskier investments trading at discounts. Forecasting future financial performance is a crucial part of Valuation. Fundamental analysts project revenue growth, profit margins, capital expenditures, working capital needs, and other financial metrics. These projections feed into valuation models like the discounted cash flow model. Assumptions around sales growth, profitability, reinvestment rates and cost of capital drive the valuation output. Fundamental analysis informs these forecast assumptions based on historical trends, competitive dynamics, and macroeconomic factors. More accurate financial projections result in better valuation estimates.

How do earnings affect Valuation?

Earnings growth is a key driver of valuation multiples and stock prices in the market, as higher profits support expanded price-to-earnings ratios, dividend increases, and greater upside in discounted cash flow models. Strong and growing earnings tend to increase a company’s Valuation and stock price, while weak or declining earnings negatively impact Valuation and share price. This is because earnings are a key indicator of a company’s financial health and prospects for future growth. Investors view companies with strong earnings growth as attractive investments that are more likely to provide returns through capital appreciation and dividends.

How to calculate company valuation from revenue?

The first step is to select a group of publicly listed companies that are comparable to the company you want to value. These peers should be in the same industry, preferably with similar products/services, business models, growth rates, size, geographic footprint and profitability. For instance, you should consider multiples of other consumer internet/social media companies like Facebook, Twitter, LinkedIn, and so on when evaluating a social media business like Snapchat. Once you have selected a good set of comparable companies, you will be able to calculate the ratio of market capitalization to revenue (also called price-to-sales or P/S ratio) for each of these peers. Market capitalization is found by multiplying the current stock price by the shares outstanding. Revenue should be the last 12 months (LTM) revenue or the most recent annual revenue. Make sure to use consistent time periods when comparing multiples. 

The next step is to take the median or average revenue multiple of the comparable companies. The median is usually preferred over the mean/average as it minimizes the impact of outliers. This median multiple is then applied to the revenue of the company being valued to get an indicative enterprise value. Assuming the median revenue multiple is 5x and the company’s revenue is Rs. 100 million, the projected enterprise value is Rs. 500 million. 

To get an approximate equity value, you might decide to take it a step further and deduct net debt from enterprise value. Compare this to the Number of shares outstanding to get a sense of the value per share. This per-share value is assessed relative to the current trading price to see if the stock is undervalued or overvalued.

What is stock valuation?

Stock valuation is the process of determining the intrinsic value of a company’s shares based on analytical techniques that estimate its assets, earnings potential, and other financial metrics to arrive at a fair value for the stock. The most common stock valuation methods include the Dividend Discount Model (DDM), Discounted Cash Flow (DCF), Relative Valuation, and Asset-Based Valuation. Dividend Discount Model (DDM) values a stock based on the present value of its expected future dividend payments. The value is calculated by forecasting dividends over a period of time, discounting them back to the present using a required rate of return, and summing the discounted dividends. Key inputs are the dividend growth rate and the required rate of return.

Discounted Cash Flow (DCF) Model values a stock by discounting a company’s forecasted future free cash flows back to the present using the weighted average cost of capital. Free cash flows are projected for a period of time, discounted back, and summed to get the stock value. Key inputs are the cash flow projections, discount rate and terminal value. Relative Valuation values a stock by looking at valuation ratios of comparable companies in stock market. The most common ratio used is the price-to-earnings (P/E) ratio. The P/E of the stock is compared to peers to assess whether it is undervalued or overvalued relative to similar stocks. Other ratios like P/B, P/S, EV/EBITDA are also used for comparison.

What are valuation multiples?

Valuation multiples are ratios used by investors to estimate the fair value of a company’s stock price. By comparing a company’s valuation multiples, such as the price-to-earnings (P/E) ratio or price-to-book (P/B) ratio, to those of similar companies or industry averages, investors gauge if a stock is undervalued or overvalued relative to its peers. Valuation multiples provide a standardized way to value companies across sectors. In the stock market, valuation multiples are widely used during financial modelling and analysis to identify potential investment opportunities. However, multiples should not be viewed in isolation, as factors like growth prospects, debt levels, and quality of earnings should also be considered when determining a stock’s fair value.

Which are the companies with the highest Valuation in India?

Reliance Industries leads the Indian market by Valuation, followed by TCS, HDFC Bank, Infosys and HUL in the top five, while ICICI Bank, Bharti Airtel, Adani Green Energy, Kotak Mahindra Bank, and Adani Total Gas round out the top ten highest valued firms owing to their competitive strengths, governance, innovation, growth and strong financials, though high valuations indicate lower margins of safety for investors.

Reliance Industries Limited (RIL) tops the list with a market cap of Rs 17.5 lakh crore as of 2023. The oil-to-telecom conglomerate led by Mukesh Ambani has interests spanning hydrocarbon exploration and production, petroleum refining and marketing, petrochemicals, retail and telecommunications. RIL operates the world’s largest single-location refinery complex in Jamnagar, Gujarat. The launch of Jio telecom services in 2016 disrupted the Indian telecom industry. Reliance Retail is now India’s largest retailer. RIL is among the world’s Top 10 companies by market cap.

Tata Consultancy Services (TCS) is second on the list, with a market valuation of Rs 13.5 lakh crore. TCS is India’s largest IT services company and provides a range of services, including application development, infrastructure support and business process outsourcing. TCS operates in over 46 countries and derives significant revenues from the US and UK. Its proprietary products and platforms, along with strategic partnerships with global companies, have enabled it to emerge as a leader in the IT services industry.

HDFC Bank is the third most valued company in India, with a market cap of Rs 9.3 lakh crore. HDFC Bank is India’s largest private sector bank by assets. It offers a wide range of banking products and services for corporate and retail customers. Conservative lending policies and best-in-class asset quality have enabled HDFC Bank to grow steadily while maintaining healthy profitability. Its widespread branch network and leadership position in digital banking give it an edge over competitors.

Infosys is next on the list with a valuation of Rs 6.5 lakh crore. Infosys is India’s second-largest IT services company. It provides end-to-end solutions leveraging technologies like cloud, big data, artificial intelligence and machine learning. Infosys helps global clients in their digital transformation journeys. Under CEO Salil Parekh, Infosys has focused on large deals, localization and expanding capabilities to accelerate growth. Its global delivery model, training facilities and emphasis on governance have made it an employer of choice.

Hindustan Unilever Limited (HUL) ranks fifth with a market cap of Rs 6.2 lakh crore. HUL is India’s largest fast-moving consumer goods (FMCG) company with popular brands like Lifebuoy, Lux, Surf Excel, Rin, Wheel, Fair & Lovely, Pond’s, Vaseline, Lakmé, Brooke Bond, Kissan, Knorr and Pureit. HUL enjoys an unmatched distribution reach of over 7 million outlets across India. The company has kept pace with changing consumer preferences by constantly innovating and tailoring its products to Indian tastes and preferences.

ICICI Bank takes the sixth spot with a market valuation of Rs 5.8 lakh crore. ICICI Bank is India’s largest private sector bank in terms of total assets and market cap. The bank offers a wide spectrum of banking products and financial services for corporate and retail customers through a variety of delivery channels. ICICI Bank has adopted technology in a big way to improve customer experience and efficiency. The bank has emerged stronger after going through a difficult period during 2018-19.

Bharti Airtel is the seventh most valued firm, with a market cap of Rs 4.7 lakh crore. Bharti Airtel is one of India’s largest telecom operators offering mobile, fixed line and DTH services. Airtel has over 480 million customers across South Asia and Africa. In India, Airtel has emerged as a strong challenger to Reliance Jio through its focus on higher revenue customers, network upgrades and content partnerships. Airtel is now looking to expand its enterprise, data centre and digital TV businesses. 

The Adani group has two companies in the top 10 list – Adani Green Energy at number 8 (market cap Rs 4.5 lakh crore) and Adani Total Gas at number 10 (market cap Rs 4.1 lakh crore). The meteoric rise of Adani group stocks has made its companies among the most valued in India. Adani Green Energy is one of the largest renewable energy companies in India, with an installed renewable capacity of over 6 GW. Adani Total Gas distributes piped natural gas to industrial, commercial and domestic customers. The Adani group’s aggressive expansion into sectors like renewable energy, gas distribution and airports has resulted in massive value creation. However, high valuations and debt levels have also led to concerns.

Kotak Mahindra Bank secured the ninth position with a market cap of Rs 4.3 lakh crore. Kotak Mahindra Bank provides banking, financial services, insurance and asset management to retail and corporate customers. Low-cost deposits, higher cross-selling, and a focus on risk management have enabled Kotak to report healthy performance. Its subsidiaries, Kota,k Securities and Kotak Life Insurance, are also market leaders in their respective segments. Kotak’s aspirational brand image and innovation-focused approach make it a leading name in Indian banking.

Arjun
Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam
Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.

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