I’m a bit new to this finance thing, and I keep hearing/reading about “valuing” a company. I just wrote CFA Level 1, so I think I saw a lot of tools for valuing a company; but my question is, how would you actually "value"a company? Is there a framework for what you check or logical steps one would take? I think I understand a lot of the tools from level 1, but I guess I’m just missing how they fit into the big picture of determining the worth of a company.
Present value of future cash flows.
Market Approach: value/earnings-measure multiples (EV/EBITDA; P/E, etc) of comparable companies.
The truth is that there are lots of ways to value a company, and, in a perfect world with perfect estimations and perfect understanding of things, they would all come up with consistent values for a company and you could use whichever one you want. But the world is not perfect and that is why fleets of analysts can’t be replaced by a single computer and/or database. The basic idea is that something should be equal to the present value of future cash flows. So for a regular bond, you know what the cash flows are (stated in the bond contract), when they are coming, and the only real trick is to figure out what rate you should discount them at, and how much to discount the whole thing for the possibility that the debtor company might default while they still owe you the bond, and whether you have any collateral or security you can recover. For equities, you could look at a stock value as the present value of future dividend payments that the stockholder might be entitled to, but now you have to figure out what the right discount rate is, AND you have to try to guess what those dividend payments are going to be. You can get around predicting dividends until the end of time by assuming some kind of terminal value, which is what you think the stock price is going to be a a few quarters or years out, but then you have to figure out what that terminal value is likely to be (most people make some assumption about what the P/E ratio is likely to be and try to link it to an estimate of earnings). This gets around the dividends-to-infinity problem but now about 80% to 90% of the final stock price probably depends on that one assumption you just made about terminal value. Other people just give up on intrinsic value and decide that what one is going to trade on are relative values like P/E, P/B, P/Sales, P/Cash Flows, and such. Price/Cash Flows is theoretically the most sound, but figuring out what the cash flows are going to be requires a lot of tea-leaf reading. Sales may be easiest to predict, and earnings probably have a lot of supporting information to keep your assumptions from going all over the place. In the relative valuation world, what you’re comparing is how much you have to pay to claim a dollar’s worth of earnings, book value, sales, etc, and the idea is that paying less is better, as long as you’re not paying less because the company is more risky. So when you do these relative valuations, you have to be careful that the companies you are comparing have similar risk properties, or that any differences in risk properties are explicitly accounted for by your comparison method. In Level II, they will introduce the Residual Income model, which I thought was kind of neat (but discovered I didn’t understand as well as I thought on test day). In the RI model, the idea is that a stock is worth its share of a company’s book value, plus any earnings achieved in excess of the required rate of return for companies of similar risk, then discounted to the present. It sounds like a mouthful, and it is, but the main advantage of the RI method is that you don’t get so much of the stock price determined by the terminal value, compared to the dividend discount model, so the quality of your earnings estimates matters more, and the quality of your terminal value estimation, while still important, doesn’t matter quite as much. Then there are valuation methods that value the entire company (Enterprise Value) either as discounted (Operating Cash Flows - Capital Expenditures) or as a multiple of EBITDA earnings. This is how much one would be willing to pay to take control of the entire operation. Once you get the total enterprise value, you can then subtract the market value of debt to get the equity, or subtract the market value of the equity to get the debt component. So now there are all these ways to come up with values, and there are lots more. You can look at Aswarth Damodaran’s classic books on valuation to see even more. The question is how to put them all together. Probably a sensible way is to get a high value and low value for each method (or whichever ones you like to use), then plot these values out on a chart and see how the prices seem to cluster. That will give you a sense of what range you think a target price should be, and hopefully it is narrow enough that you can make some sensible judgement about whether to buy or sell the security, company, etc… Anyway, that’s the big picture view.
bchadwick, thanks for taking the time to write that response. The picture is still a bit fuzzy, probably because I’ve never worked in finance before., but you provided a good overview and a good starting point for learning more. Thanks a lot, I appreciate it.
bchadwick Wrote: ------------------------------------------------------- > The truth is that there are lots of ways to value > a company, and, in a perfect world with perfect > estimations and perfect understanding of things, > they would all come up with consistent values for > a company and you could use whichever one you > want. But the world is not perfect and that is > why fleets of analysts can’t be replaced by a > single computer and/or database. > > The basic idea is that something should be equal > to the present value of future cash flows. So for > a regular bond, you know what the cash flows are > (stated in the bond contract), when they are > coming, and the only real trick is to figure out > what rate you should discount them at, and how > much to discount the whole thing for the > possibility that the debtor company might default > while they still owe you the bond, and whether you > have any collateral or security you can recover. > > > For equities, you could look at a stock value as > the present value of future dividend payments that > the stockholder might be entitled to, but now you > have to figure out what the right discount rate > is, AND you have to try to guess what those > dividend payments are going to be. You can get > around predicting dividends until the end of time > by assuming some kind of terminal value, which is > what you think the stock price is going to be a a > few quarters or years out, but then you have to > figure out what that terminal value is likely to > be (most people make some assumption about what > the P/E ratio is likely to be and try to link it > to an estimate of earnings). This gets around the > dividends-to-infinity problem but now about 80% to > 90% of the final stock price probably depends on > that one assumption you just made about terminal > value. > > Other people just give up on intrinsic value and > decide that what one is going to trade on are > relative values like P/E, P/B, P/Sales, P/Cash > Flows, and such. Price/Cash Flows is > theoretically the most sound, but figuring out > what the cash flows are going to be requires a lot > of tea-leaf reading. Sales may be easiest to > predict, and earnings probably have a lot of > supporting information to keep your assumptions > from going all over the place. In the relative > valuation world, what you’re comparing is how much > you have to pay to claim a dollar’s worth of > earnings, book value, sales, etc, and the idea is > that paying less is better, as long as you’re not > paying less because the company is more risky. So > when you do these relative valuations, you have to > be careful that the companies you are comparing > have similar risk properties, or that any > differences in risk properties are explicitly > accounted for by your comparison method. > > In Level II, they will introduce the Residual > Income model, which I thought was kind of neat > (but discovered I didn’t understand as well as I > thought on test day). In the RI model, the idea > is that a stock is worth its share of a company’s > book value, plus any earnings achieved in excess > of the required rate of return for companies of > similar risk, then discounted to the present. It > sounds like a mouthful, and it is, but the main > advantage of the RI method is that you don’t get > so much of the stock price determined by the > terminal value, compared to the dividend discount > model, so the quality of your earnings estimates > matters more, and the quality of your terminal > value estimation, while still important, doesn’t > matter quite as much. > > Then there are valuation methods that value the > entire company (Enterprise Value) either as > discounted (Operating Cash Flows - Capital > Expenditures) or as a multiple of EBITDA earnings. > This is how much one would be willing to pay to > take control of the entire operation. Once you > get the total enterprise value, you can then > subtract the market value of debt to get the > equity, or subtract the market value of the equity > to get the debt component. > > So now there are all these ways to come up with > values, and there are lots more. You can look at > Aswarth Damodaran’s classic books on valuation to > see even more. The question is how to put them > all together. Probably a sensible way is to get a > high value and low value for each method (or > whichever ones you like to use), then plot these > values out on a chart and see how the prices seem > to cluster. That will give you a sense of what > range you think a target price should be, and > hopefully it is narrow enough that you can make > some sensible judgement about whether to buy or > sell the security, company, etc… > > Anyway, that’s the big picture view Good job, bchadwick! Any good book on valuation to recommend? I mean real good one–deep insight but easy to read.
Aswath Damodaran is the classic on valuation of pretty much everything. He has some free stuff that you can find by googling his name, and his books on valuation (just enter his name on amazon) are good. The tome I wrote above was mostly what I have learned from the CFA curriculum and a lot of external reading. I’ve read parts of Damodaran’s books and find it pretty straightforward to read. I’m not sure what to suggest for getting the insights quickly.
bchadwick - do you work in ER? I remember meeting you at the Stalla L2 classes at disgusting Hotel Penn, but can’t remember what you do again…
I totally agree with bchadwick. Damodaran is the right choice if you’re interested in valuations. But after completing “Investment valuation” - A.D., I can only say that this book is not for beginners. Haven’t read “Damodaran on valuation” yet, but after a few glances it seems like copy+paste most of the time. Beside Damodaran, I can only add this fantastic book “Valuation: Measuring and Managing the value of companies” -McKinsey & Company.
drs - Hey, was that you at Stalla L2 last year? I remember meeting someone from AF there, but I didn’t connect the face to the forum name. Funny how that is. Are you doing Stalla for L3? I’m an independent consultant these days, still looking for something full time in asset management, pref something that uses some of my quant, macro and strategy skills. So far, I’ve found that the greatest demand for my skills is in finding ways to talk about various products so that a basically intelligent non-specialist can understand it, like some quantitative strategies, carbon offset futures, residential housing futures, global macro etc… I like working with people a lot, but I still want something that uses my technical skills. However, the best pay I’ve ever gotten per hour of work seems to be translating some marketing research from Portuguese to English, a short little job I’m doing right now. Go figure! The challenge I face is that I’m overqualified for a lot of entry level stuff that I never get called for, and not sufficiently experienced for the senior stuff that I actually get called in to interview for now and again. I’ve decided that I may better suited to being a fund-of-funds analyst, because I like to understand different investing/trading strategies and fit them into a macro view. I also have a lot of past experience in understanding human decision-making processes, and that seems to connect well to evaluating investment decision processes. Tt this point, though, any experience in a buyside firm would be good for me… let me know if you know of anyone who’s looking! 
No stalla for L3, not yet at least. I will probably attend their mock-exam as I thought that product was the best and clearly was the wake-up call that I needed a few weeks before the exam… you can reach me over email at cfanyc3 at gmail
bchadwick - that was a good post. When did you adn drs take the Stalla L2? I was in the class with Olinto prior to the June 2007 exam. Going for L3 now, but not taking a live class.
yeah, that was the class i was in
Yeah, Damodaran is good, but the reading is kind of dry. I said straighforward, but I on second thought, it’s probably straightforward only once you’ve gotten into the basic mindset and can see how each model addresses some aspect that you have to make guesses about. I thought Hamilton Lin’s series on valuation and modeling in “Wall Street Training” was good. I took his HOW TO VALUE A COMPANY (with emphasis on M&A) course at NYSSA and it helped a lot to see how all the CFA things I learned at L1 came together. I also did the Wall Street Training module on building a financial model in Excel (basic) and liked it. None of the excel stuff was rocket science, but CFA doesn’t really help you put the parts together so well, and this course did. Both are available on the internet (I did the “valuing a company” part as a live class and the excel part online. They are a little bit pricey, but worth it, as long as you aren’t using your rent-and-eating money to pay for it. Personally, I’d recommend the online version, because it’s easier to go back over parts that were a little unclear, and you have access to it for something like 6 months after you’ve started, so you can review if you want to.