An important aspect or attribute of a business is its valuation.
Knowing the firm’s worth becomes increasingly important as a business expands, especially when the company wants to raise money, borrow money, or sell a piece of the business.
Before investing in a company, investors research its financial standing and prospects. The valuation of a company is one approach to evaluating it before investing. However, several variables affect a company’s valuation, including market and industry performance, exclusive goods or technology, and growth stage. This article explains what a company’s valuation is and how it is determined.
What exactly is a company’s valuation?
The method or procedure used to calculate the real value of a company’s stock or the fair market value of a firm is called company valuation. Estimating a business’s fair market value or intrinsic worth is what a company valuation means. Several factors are considered when valuing a firm to determine whether it is undervalued, overpriced, or trading at par.
One can choose to sell, acquire, or hold a firm’s stock depending on the market value of the company (the price at which a stock can be bought or sold in the present marketplace) and the intrinsic value (the stock’s actual value based on genuine value). One should sell a company’s shares when its market value exceeds its intrinsic value. One should purchase a company’s stock when the intrinsic value exceeds the market value.
How is a company’s value determined?
The valuation of a company cannot be calculated or determined using a single formula or a universal formula. There are numerous approaches-based strategies for valuing companies. Each strategy uses a distinct set of formulae to estimate the organisation’s value for various goals. Let’s examine the various approaches to valuing a firm that individuals can use.
Asset Method
The simplest method of valuing a firm is to use its Net Asset Value (NAV). The fair value of each asset, including those that depreciate and those that don’t, is used to determine the NAV. Every asset is considered since the fair value may differ from the latest recorded value for an asset that depreciates or the purchase price for an asset that doesn’t. When valuing a company with a large amount of tangible assets, where it is simpler to determine the fair value than for intangible assets, the asset-based approach is applied.
Approach to Discounted Cash Flows
By discounting future cash flows at a suitable rate, the discounted cash flow approach calculates the current value of those cash flows. To determine the current value of the cash flows, the Weighted Average Cost of Capital (WACC) is typically employed as a discount rate. It makes an estimate of the return on investment for the investor. The company’s valuation is calculated by discounting the predicted cash flows over a long period of time.
Market Strategy
The relative valuation method is another name for the market approach. The most typical method for stock valuation is this one. By comparing the value of a company with comparable assets using metrics like the PE ratio, PS ratio, and PBV ratio, among others, one can estimate the value of a stock. Since businesses vary in size, these ratios provide a more accurate picture of their performance. They are used to determine various stock valuation parameters.
Price to Earnings Ratio (PE Ratio)
Divide the stock price by the earnings per share to get the price-to-earnings ratio. This method is frequently employed to determine whether a company’s stock is overvalued or undervalued. The equity value is calculated using the earnings after tax as a multiple. To calculate an appropriate PE ratio, one must take into account the history of the profit after tax.
Price to Sales Ratio, or PS Ratio
In comparison to the PE ratio, the price-to-sales ratio provides a more accurate value of a company. The distortions in the capital structure have no impact on the sales number in this statistic. It is computed by dividing the share price by the total amount of sales for the company. The share price divided by the companies’ combined net annual sales can also be used to determine it. When a corporation does not consistently generate profits, the PS ratio is helpful.
Price to Book Value Ratio (PBV Ratio)
A common approach of determining a company’s valuation is to use the price-to-book value ratio. It is determined by dividing the stock price by the book value of the stock. However, future earnings and intangible assets of the organization are not taken into account by this metric. Because their revenue is based on the value of their assets, some businesses, including banking, employ this strategy.
Earnings before interest, taxes, depreciation, and amortization, or EBITDA
Earnings before interest, tax, depreciation, and amortization is the most dependable ratio. In this metric, profits are taken into account before tax, interest, or loan amortization are computed. This ratio is not distorted by the capital structure, non-operating income, or tax rates.
formula for valuing a company
The company valuation cannot be determined or calculated using a single formula, as was already mentioned. The various formulae employed to determine a firm’s worth under various company valuation procedures are shown below, nevertheless.
Asset-based formula
The fair value of a company’s assets is subtracted from its outstanding liabilities to determine its net asset value (NAV).
Therefore, Net Asset Value, or NAV, is the total of all the company’s outstanding liabilities less the fair value of all the company’s assets.
Formula for the discounted cash flow approach
The discounted cash flow is determined by dividing the present value of the expected future cash flows by the appropriate rate of discount.
Discounted cash flow is equal to first-year cash flow / (1 + r).1 + 2nd-year cash flow / (1 + r)nth year cash flow/(1+r)n + 2 +..
Here, r is the weighted average interest rate or capital cost.
PE Ratio Calculator
The PE ratio is calculated by dividing the stock price by the earnings per share.
Stock price/earnings per share (PE Ratio)
PS ratio equation
The PS ratio is computed by dividing the share price by the total amount of sales for the company.
PS ratio is calculated as Share Price/Total Sales.
By dividing the share price by the net yearly sales per share, it may also be determined per share.
The PS ratio is the stock price/net yearly sales per share.
PVB ratio equation
By dividing the stock price by the stock’s book value, the PVB ratio is calculated.
PBV ratio is the stock price to the stock’s book value.
As a result, if the PBV ratio is 4, any stock with a book value of Rs. 10 has a stock price of Rs. 40.
EBITDA equation
EBITDA/net sales of the company is the EBITDA to sales ratio.
Since tax, interest, depreciation, and amortization are deducted from earnings, EBITDA will always be less than 1.
Examples of company value
Figure 1:
XYZ Ltd.’s share price as of right now is Rs. 190. The terminal cash flow value is Rs. 300 per share for the following five years. 10% is the cost of capital.
The value per share, determined using the discounted cash flow approach, is Rs. 186.27, or Rs. 300/(1 + 0.10) 5]. Shares are currently trading at Rs. 190 each. A company’s shares may be purchased because the market price of a share is less than its intrinsic worth. Overvaluation suggests selling, while undervaluation presents a purchasing opportunity.
Figure 2:
The automotive industry’s typical PE ratio is 5. The earnings per share for company ABC Ltd. are Rs. 40, and the share price is Rs. 100. Earnings per share are Rs. 10, and the share price of XYZ Ltd. is Rs. 80.
ABC Ltd. has a PE ratio of 2.5, or 100/40. Company XYZ Ltd. has a PE ratio of 8 or 80/10. firm XYZ Ltd has a high P/E ratio compared to firm ABC Ltd’s low P/E ratio. As a result, firm ABC Ltd. is cheap and might be a smart investment for an investor, as opposed to company XYZ Ltd., which is overvalued and might not be.
FAQs
1. How may equity be used to value a company?
Market enthusiasts frequently use the market capitalization approach to determine the equity-based firm valuation. It determines a company’s market value, as defined by the stock market. Multiply the number of outstanding shares by the share’s current market value to determine a company’s market capitalization.
The market capitalization formula is as follows:
Stock price multiplied by a company’s value. Total amount of shares outstanding
Although many businesses use a combination of debt and equity to finance themselves, the market capitalization technique takes equity valuation into account.
2. How can I estimate a company’s value using its revenue?
A company’s revenue-based valuation is determined by taking its entire revenue, deducting operating costs, and multiplying it by an industry multiple. The industry multiple represents the average price at which businesses typically sell in a certain sector. As a result, businesses typically sell for twice their yearly revenue and sales if the industry multiple is two.
This technique of valuing a firm can also vary since some businesses base their valuation on revenue from the previous 12 months, revenue projections for the following 12 months, or a combination of 6 current months’ revenue and 6 projected months’ revenue.
3. How do you value a firm based on investments?
The enterprise value approach is used to determine the investment-based company valuation. It considers various financial arrangements, including cash, debt, and equity, to value the organization.
The enterprise valuation method’s formula is as follows:
Debt + Equity – Cash equals the company’s valuation.
Investors can rely on this valuation to mitigate market risks because it uses the enterprise value method, which takes into account all capital sources. However, drawing the wrong conclusions from the enterprise value method might be dangerous for high-debt industries.
4. What formula is used to determine a company’s value?
The valuation of a corporation cannot be determined or calculated using a single formula. Under various companies, valuation methodologies utilise several formulas to determine a company’s valuation.
5. Which Indian businesses have the greatest valuations?
According to the market capitalization approach as of February 7, 2023, the top five Indian corporations by valuation are as follows:
- Reliance Industries: 1,563,887 crores in market capitalization.
- TATA Consultancy Services: 1,266,031 crores in market capitalization.
- HDFC Bank: Rs. 921,311 crores in market capitalization.
- Infosys: 660,879 crores in market capitalization.
- Hindustan Unilever: 620,996 crores in market capitalization.
