Valuation

 Valuation is the Buzz word for all finance guys in the financial market. But what is valuation. Valuation basically means what a company is worth now and likely to be in future.

While what a company is worth now can be obtained from its assets and liabilities in the balance sheet as well as how it has done in the past, valuing a company in the future is at best a shot in the dark. Why do I say that? Because nobody can predict the future. Future is so uncertain and has political, policy, regulatory, business impact, alternate business impact, competition and so many other variables to correctly predict the future.

When it is difficult to predict what is going to happen in the next minute (if it can be predicted, there will be zero accidents or disastrous events), how can one look at a crystal ball of the future many years hence.

Another non physical factor in a Valuation is a bias like if your job is to do a valuation for a client, you will try to match the figures of valuation that looks nice to the client, irrespective of what your model says. eg. If your model growth of sales is 5% and you value the company at $50 and client's expectation is $100, you tend to bump up the sales growth to 15% or 20%. This bias is evaluator bias as he wants to finish this deal with the client and earn a fat bonus for himself. How else does one explain a Paytm valued at 2000 Rs and crashes to 400 Rs or many such IPO companies.

Valuation also depends on the bias you carry because of the environment you live in. Eg ITC was poorly valued a few years back and even if somebody had valued  at that time, he would have valued at 150 Rs or 200 Rs. Now with the prices touching 600 Rs, if the same evaluator does the valuation he will do around Rs 550-600. This bias of going towards the market price valuation happens because you do not want to be proved wrong. If it goes down, you can always say, Everybody said so. You do not want to put your head out like the guy Michael Burry - on whom the movie The Big Short was made. He bet against the market in 2008, as his data showed him it was going to crash. Very few in the world can take such a contrarian call.

So, how do we value a company. My personal belief is the PE ratio should be reasonable (<20 or what is the average in the industry and much less than that. Eg Tech PEs are 60-80. I prefer valuing them at 30-40- even a 50% drop is bearable. Why do I do that? Tech is a very unpredictable beast. Anything can happen with in matter of days or months. Nokia is one eg, Netscape is another, Lotus 123 the pre excel pioneer, EVs of today and possibly AIs of the future. AIs can technically replace CAs, Lawyers, MBAs or knowledge based industry. MIT courses, for eg are available for free on You tube and so many other DIY courses for which once upon a time you paid huge amounts to learn.

I follow the following 5 pointed star valuation

a) PE at a reasonable rate (<20)

b) Sales Growth - 3-5 years - growing at 15-20% per year (Rolling returns)

c) Ebitda - 3-5 years - growing at 15-20% per year

d) ROCE- 3-5 years growing at 15% per year

e) ROI -3-5 years growing at 15% per year

If all the boxed at b) to e) get ticked and PE is <20, I multiply the EPS * PE to get the value of the company.

I do not say, I will be right all the time, but hopefully most of the time as stock prices are a function of many factors- momentum, shorting, margin calls, valuation bias and a lot more.