What is a valuation?
A valuation is an assessment of the value of a company. This is measured in dollars and is usually represented as a share price - i.e. the total equity value divided by the number of shares.
The market price is what a willing and able buyer is prepared to pay. For a number of reasons the price may be different to a valuation - i.e. a temporary mis-match of buyers or sellers or lack of relevant quality information about a company. As additional information is released or market circumstances change the price and/or valuation will move to reflect these changes. You would expect them to converge over time.
What is a share price?
Most people struggle to answer this simple question: “what is a share price?”. People often have an opinion on whether the share price of a given company is too low or too high – but they usually can’t explain “why?” or determine what the price should be in any structured way.
At Valuecruncher we are aiming to change that.
Valuecruncher is a tool that allows anyone to complete a public company valuation. Valuecruncher uses the same framework that is used by most corporate finance professionals in the investment banking, equity research and funds management industries. That framework is called a discounted cash flow (DCF) analysis.
How does DCF analysis work? In simple terms a business is worth the present value of the cash flows that it will generate into the future. Those are the after tax cash flows available to shareholders – from today to forever. To calculate the after tax cash flows available to shareholders you will start with the revenues a business generates and deduct all the cash-based expenses that are incurred in obtaining those revenues (including taxes and capital expenditures).
The DCF analysis takes two pieces of information to determine the present value of the cash flows:
- An estimate of the cash flows into the future. We use 3-years of forecasts and then an estimate into perpetuity; and
- An assessment of the potential variability of those cash flows, called the discount rate. In other words, are the cash flows stable or do they jump about? The bigger the cash flows and the less the variability the better.
The DCF analysis assumes that cash flows today and in the near-future are worth more than cash flows further into the future. How much more depends on the discount rate. The higher the discount rate (the more variable the cash flows) the less they are worth in the future.
The total present value of the future cash flows of a business is called the Enterprise Value. This gives us the total value of the business, including both debt and equity.
So, to calculate the value of shareholder equity (often called "market capitalisation" for listed public companies), we just need to subtract Net Debt from the Enterprise Value.
Net Debt is the long-term borrowings (i.e. bank debt) less cash or equivalents. If the company has more cash than long-term borrowings that is fine – Net Debt is negative and so adds to Enterprise Value.
Finally, to then determine a value per share we simply divide the value of shareholders equity by the number of shares outstanding.
That is the long answer to the “what is a share price?” question!
When we explain this framework people typically start asking questions about working capital – payables, receivables, etc. We deal with these in the cash flow – adjusting for changes in these variables. Calculating a share price is actually a reasonably simple equation. Sorting out estimates of cash flows and their variability can be more challenging.
A professional considering the valuation of a company would normally complete some additional analysis in addition to the DCF analysis. Firstly, they compare earning multiples of comparable companies. Also, they look at the net assets of a business - usually the Net Tangible Assets (NTA). NTA is the physical assets (total assets less intangibles – i.e. goodwill or amortised software costs) less liabilities from the balance sheet. This gives a baseline valuation number.
NTA is often what people think of when they try to answer the “what is a share price?” question.
An example – Microsoft has total tangible assets of US$58.7 billion and total liabilities of US$36.5 billion (30 June 2008) and with 9.15 billion shares outstanding has a NTA of US$2.43 per share. The current share price is US$27.40 (September 2008) – NTA explains only 9% of the share price.
So where is the value? Look at the cash flows.