How much is Apple worth after publishing a drop in sales? Is Amazon’s title overrated? How much should Tesla be worth? To all these apparently simple questions, fundamental analysis answers – or rather, tries to do it. This essentially establishes the correct price of a security based on the intrinsic economic and financial characteristics of the company. In particular, the fundamental analysis evaluates the capital solidity and profitability of a company, thus arriving to determine the fair value of the same and consequently of its shares (if it is listed on the stock exchange). Company valuation can be done according to numerous approaches, however the most used methods are Discounted Cash Flow Valuation (DCF) and the Relative Valuation.
Carry out the company evaluation with the Discounted Cash Flow Valuation
DCF is essentially based on a company’s cash flows , considering both future cash flows and dividends paid. The value of an asset (or of an entire company) is equal to the present value of these cash flows on that particular asset. As can be easily understood, the elements to be taken into consideration in this methodology are mainly:
- The life of the asset, that is, for how long the cash flows will be generated;
- Cash flows, ie their amount over time and relative growth;
- The discount rate , that is the rate used to discount the cash flows.
Apparently this model would seem very simple, being a function of only three parameters; however the reality is very different and there are many critical issues. First of all, it is necessary to estimate a discount rate consistent with the assessment that is being carried out, that is, that reflects both the riskiness of the company (therefore the possible default risk) and the surrounding macroeconomic environment (country risk, expected inflation …). All these components must be reflected in the rate used to discount future cash flows.
Furthermore, the period and expected growth rate of cash flows are particularly difficult to estimate. Growth in particular depends on the fundamental and intrinsic characteristics of the company, as well as on the market in which it operates. For example, a company active in a market where there are strong barriers to entry will be able to maintain its current margins for longer than a company operating in a perfectly competitive market. In addition, a small company will be able to achieve greater growth than a large one (think in this case of the BCG Matrix and the relative positioning of a company).
As for the life of the asset or of the company itself, many analysts distinguish between listed companies and private companies. For the former it is commonly assumed that they will continue to grow at a constant rate (less than or equal to the rate of growth of the economy), while for the latter, in some situations it can be assumed that the company is liquidated upon the death of the entrepreneur ( ” Liquidation approach “). A critical issue linked to constant growth, ie stable growth , is to establish how the transition between the different growth periods will take place, that is, what phases the company will go through before reaching this situation.
All this information and assumptions, necessary to arrive at a correct company evaluation, take a long time and can make the DCF easily manipulated; for this reason, many analysts often prefer to resort to Relative Valuation.
Company evaluation with the Relative Valuation
The Relative Valuation (or multiples method) is based on the price of comparable assets, that is, of other companies belonging to the same sector of the company in question. Mathematically the multiple is a relationship whose numerator is generally represented by the value of the company, while the denominator is represented by a variable capable of resuming in itself the company’s ability to produce wealth. The multiples usually used are the P / E ( Price / Earnings ), the EV / EBITDA ( Enterprise Value / Earnings Before Interest, Taxes, Depreciation and Amortization ) and the PBV ( Price to Book Ratio ), but you can use any multiple that has an economic meaning and that can also be applied to competitors. These multiples are used to link the relationship between the current price and the balance sheet data of the company being analyzed.
This method is much faster than DCF as it requires a limited number of inputs and assumptions, since some of them are implicitly contained in the multiple itself. However, it is important to emphasize that there are no double companies, that is, with characteristics that are perfectly similar to those of the company to be evaluated (ie equal cash flow, growth and risk); for this reason it is necessary to consider these differences, to avoid incurring misleading results. The choice of comparable companies is also extremely subjective and this can lead to numerous manipulations. Finally, this methodology, based on the market price, can lead to results that are often influenced by the so-called ” market mood”, That is, from possible phases of excessive euphoria (for example, the Relative Valuation applied in the early 2000s to dot-coms , a phenomenon we discussed in this article ) or depression.
All methods have advantages and disadvantages, but it must always be borne in mind that corporate Business Valuations in Dubai, even if often using complex models, is not a science. One can only try to arrive at an evaluation as precise as possible on the basis of reasonable assumptions.