Company valuation for investment decision making
Company valuation purpose
Company valuation is an essential task to evaluate the current price level or to determine the initial market price. Let’s look at the formula below to see how important company valuation is.
Return on investment = Pt / P0
P0: Purchase price of an investment asset at present
Pt: Exit price of the asset in the future
Return on investment is the yield obtained by dividing the exit price by the purchase price. To evaluate the level of the current price P0, you need to value the target company. After that, if you judge that P0 is cheap or appropriate, you buy it. If P0 seems higher than the value you believe, you may withdraw your intention to invest, or negotiate the price, or wait for another chance. For those investment decision making, valuation is critical as it has a significant effect on the return on investment by evaluating P0.
You will also do a valuation to decide the level of exit price Pt to earn your target rate of return. If you reckon that you have already reached it, you may sell your assets earlier than planned. A valuation about Pt not only tells you the target rate of return but also help you to decide when to sell. After all, company valuation affects both P0 and Pt and plays a crucial role in realising the return on investment.
The roles of company valuation are following;
Investment decision making
Valuation is an essential work for stock investment. Without it, investing is like speculating because you bet your money on an asset that you don’t know how the price would change. It is no different from speculation awaiting random results. In the process of company valuation, you get to see the company business and estimate the size of the cash flow that it would generate. The more robust and analytical valuation you perform, the closer to the fair value of the asset you will be. In a book entitled “investment valuation,” written by Damodaran, a renowned professor of finance at New York University, there is an article like this:
“A postulate of sound investing is that an investor does not pay more for an asset that it’s worth.”
In the text above, you can consider the two words ‘pay’ and ‘worth’ as ‘price’ and ‘value’. Reflecting that and reinterpreting the text, it means a wise investor does not pay more than the value of an asset. Not to buy it at a higher price than its value, you need to conduct the valuation and evaluate the value. That is basic, but many investors could overlook.
Investment premise: Value > Price
The stage of an investment target company can be classified into venture, growth, mature, or distressed according to its life cycle. It can also be divided into listed or private. As the types of company status vary, the choice of valuation methodology is important. We will get to know it step by step.
Participants in M&A events are either buy-side or sell-side. M&A valuation is essential for both. However, it may become more critical to buy-side if capital is more abundant than investment target companies in the market. That is because the demand for the assets is more than the supply so that the prices may rise.
Buy-side conducts valuation to know the fair value of the deal before investment decision making. The deal value may be decided by auction or private negotiation, depending on the deal types. When they are tender offer or selective disclosure, the role of the valuation may become more important. That is because if the atmosphere becomes competitive, the buyers’ judgment could become blurred, and if they pay the price higher than the value, they could face ‘the curse of the winner’.
Sell-side performs valuation to estimate the exit price. If a deal type is a tender offer, the valuation would be a role of suggesting the seller’s initial desired deal price. When it is a private negotiation, depending on the strategy, sell-side may first offer a desired ask price, or buy-side may first give the desired bid price. What is common for both, the sell-side could have the reasonably fair value of the deal through valuation and have the bargaining power based on that.
The difference between both sides is that the buy-side needs to find a synergy effect from the acquisition by valuation. Synergy means an added value that the buy-side would be able to create through the takeover. Suppose that Firm A and Firm B have values of 10 and 5, respectively. The sum of the two is arithmetically 15. However, if A could create synergy by acquiring B, the sum should be 16 or more. The buy-side needs to find the synergy effect that is more than 1 in the valuation.
Equity capital raising
Equity capital raising is essential for companies to grow. Venture firms raise funds from venture capital, private companies do it through IPOs when they go public, and listed companies raise follow-on capital on the capital market. On the other side, investors value them for investment decision making. By evaluating their stock price, investors determine the level of the investment scale and the corresponding stake ratio. For companies that raise capital, it is advantageous to issue stocks with a lower stake ratio to investors through a high valuation. Conversely, for investors, it would be better to secure a high stake through low valuation.
Company valuation is also used for several other purposes. Typically, analysts working in investment banks or research institutions do valuation to write equity research reports. The purpose of their valuation is to judge the current share price level. They give a hold or sell opinion if the current share price is higher than the assessed value, or a buy opinion if it is lower. The target companies are mainly listed ones, and they usually publish more reports about companies that investors are more interested in.
Financial institutions such as asset managers or pension funds perform valuation to evaluate their portfolio. That allows them to estimate the value of them and calculate the return accordingly. Meanwhile, the performance of their portfolio may vary depending on which valuation methodology they apply.
Companies do a valuation to know the value of themselves for some reasons; granting stock options to employees, stock succession, assessing the management performance, calculating the debt ratio, and mediation between investors on ownership dispute.