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FAQs on how to value a company’s shares

Srinivasa Sharan
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FAQs on how to value a company’s shares
  1. What are the different methods to value a company’s shares ?

There are two main methods for valuing a company’s shares. The first method to value a company is the comparative valuation method. Under the comparative valuation method, a company’s share price is benchmarked against other similar companies in the sector using select parameters like the PE, Price to Book, Price to Sales ratio etc. An investor then chooses a company for investment when the comparative ratio is attractive compared to the selected company or sector. The second method for valuing a company’s shares is the use of the discounted cash flow (DCF) method. Under this method the investor estimates the cash flow for equity investors over the medium to long term by forecasting these cash flows and making some assumptions accordingly. These future cash flows are then discounted using the Cost of Equity to estimate the Present Value per share. If the present value of the share is more than the current market price of the company, the investor chooses to invest in the company.

  1. How are the future cash flows forecasted under the DCF approach?

The first step in a DCF approach to valuation is to create a basic financial model in an excel spreadsheet. We must then input/enter the company’s financials for the last three years. We would then estimate important parameters such as sales growth for the forecast horizon (i.e next 3 to 5 years) by assuming (after industry analysis) a future trend in sales growth. We also look at the operating income and EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) margins and estimate what these margins would be over the next 3 to 5 years based on analyzing where the company would be within the sector.

  1. How do we choose the cash flow forecast horizon for valuation?

All companies at some point stabilize in their growth trajectory. While high growth companies may growth at a high rate in the short to medium term, low growth companies may only grow their cash flows at the steady rate in the medium to long term. In the case of high growth companies, we can assume a 3 stage growth model, where growth is at a high rate in the first few years, and then lowers to a moderate rate say after 3 years and is finally followed by a long term steady growth rate.

  1. How is the discount rate for the discounting of cash flows estimated?

The discount rate for the discounting of cash flows is estimated using the long-term risk-free rate i.e usually the long-term government bond yield and the equity risk premium. There are several factors which go into determining the equity risk premium. Some of these include Investors risk aversion, level of uncertainty about the economy, level of uncertainty about inflation, government policy and political uncertainty, monetary policy, liquidity and FII inflows.

 

 

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