Applications of Equity Valuation

“Valuation” or the process of assigning a fixed numerical value to the present and potential of a business is considered by many experts to be the most important part of corporate finance and financial markets. The most coveted and highly paid jobs in the financial markets are in this domain.

The reason for this is that the accuracy of the value derived can never be known. It is not a verifiable fact and there is no right or wrong answer. Rather, the valuation is an opinion that is based on the expertise of the person conducting the exercise.

Now, if we take the subjectivity and add to it the fact that decisions involving billions of dollars have to be taken based on the valuation, we see why it is arguably the most important task in finance. Let’s see the kind of decisions that need to be made based on the value derived from equity valuation.

Stock Picking

The most common application of equity valuation is related to stock picking. In a world with perfect markets, stock picking would be a futile exercise. All the stocks would always be valued correctly and it would be impossible to make any supernormal profits from investing in these stocks. However, fortunately or unfortunately, we do not live in this world with perfect markets.

The theory of stock selection is based on the flaws of the market. The belief is that in the short run, due to investor euphoria or pessimism, stocks tend to be valued on the market at more or less price than what they are actually worth.

Thus, if one has an objective basis to find out the true intrinsic value of these stocks, one can gain while buying in a depressed market and selling later when markets return to normal.

Therefore, it is implied that any investor must always have their own estimate of value of the stock, which they derive from their very own equity valuation model. Then they must constantly be on the lookout for undervalued stocks or as Warren Buffet puts it, “dollar bills which are selling for ten cents in the market.”

Estimating the Market Sentiment

This is a slightly unconventional application of the field of equity valuation. Now, there are times when the market can be seen to be clearly euphoric and there are other times when the market seems to be clearly depressed.

However, sometimes the signals may not be so clear and investors may be clueless as to what the market’s expectations of the future are.

In this case too, equity valuation can come to the rescue. The idea is to arrive at a fair valuation and then compare them with the values prevalent in the market. If the market is overvaluing most of the stocks, then investors are expecting a positive future and the sentiment is positive. The converse of this is also true. Hence, equity valuation can be used as a tool to read the market.

Listing Of Private Businesses

Private businesses and capital markets have a symbiotic relationship. Private businesses can obtain cheap funds from the capital markets, whereas investors get a chance to invest in lucrative businesses by being in the capital markets.

However, when a private business initially lists itself on the market and becomes a public company, it faces a problem. How do the owners and investors know what the correct value of the business is? What is the right price for the investors to pay and for the owners to accept?

Well, once again the art and science of valuation comes to the rescue. Using equity valuation models, analysts can arrive at a relatively precise price supported by facts and data which is usually acceptable to both the counterparties involved in the trade.

Valuing the business is therefore the number one task that needs to be performed by merchant bankers when they plan on taking a company public.

Mergers and Acquisitions

Lastly, just like listing of private businesses, there is also considerable ambiguity over the price to be paid when mergers and acquisitions happen. How do the investors of both companies know that they are getting a fair deal? Well, once again, equity valuation comes to the rescue. The valuation exercise here is quite complicated. First both individual entities need to be valued and then the combined entity needs to be valued. Then gains from merging the business or “synergy” have to be found out.

Later, based on the bargaining power and the risk-reward bearing agreement of the venture, a fair valuation can be arrived at which is acceptable to both the acquirer and the acquired.

To sum it up, valuation is the lifeblood of financial services. All sorts of organizations, from merchant banks to portfolio management companies need this knowledge. Also, it is an imperfect knowledge hence companies are willing to spend more and more money to hire people they believe have a good understanding of the concept of valuation.