What is valuation

What is valuation?


Valuation determines how much an asset is worth. One can determine the worth either through market mechanisms such as what similar items are selling for in the market or if the asset has a defined cash flow stream, discounting them to calculate present value. The former approach is called relative valuation and the latter, fundamental valuation. But not all assets have a defined cash flow stream. You buy a piece of land at a price others are willing to pay for – example of relative valuation. But one can’t value using fundamental analysis as it doesn’t have any future cash flows.

Security like stock or a bond can be associated with future cash flows; hence can be valued using fundamental valuation.

Different kinds of valuation approaches

There are primarily 2 valuation approaches:

- Valuation driven by fundamentals like future cash flows – Fundamental valuation.

A Government Bond with a cash flow of Rs. 10 year from now is worth PV(10,discount-rare) – Present value of Rs. 10 today calculated by discounting 10 @ 1 year Indian Govt. interest rate. This is a very simple cash flow and a simple discounting without taking into account risk premium, capital structure and calculation of cash flows. Valuing a company requires zillion of assumptions in determining its present value, but the principle behind valuing a company is similar to one for bond in the example, albeit the degree of complexity is very high. Although this valuation approach is the most difficult to implement, if done correctly, and requires a long term horizon, it is market agnostic (fundamental valuation will continue to give you same valuation irrespective of market’s mood swings)

- Valuation driven by market moods such as degree of risk aversion (high risk aversion in recent crisis) or liking for a particular sector (IT in dot com bubble) – Relative valuation. If you have to buy a property, you will see what people are willing to pay for similar property in similar neighborhood and that will be its price. This is an example of relative valuation where you compare the prices of relatively similar assets. This valuation is driven by market mood swings – for example if market’s appetite for risk is high like in dot com or in 2007 before financial meltdown, people will be willing to pay higher prices for same asset than during 2009, characterized by high risk aversion. This approach is similar, but at the same time, suffers from the drawback that valuation changes with market moods.



Note: There is another valuation approach for depressed companies which are driven by the option component in the equity value. This one is for advanced readers and I may try to address this at the end.



Technical analysis, on the other hand, is driven by market demand and supply rather than fundamentals. (It can be argued that demand/supply may be indirectly driven by fundamentals)





In the future sections, I plan to take fundamental and relative valuation and get into greater detail taking a real company example.