What is valuation and why is it important?

What is valuation and why is it important?


How India is moving forward to establish an independent valuation industry with the advent of the Insolvency and Bankruptcy Board of India (IBBI) Valuation Examination.

In India, the genesis of the valuation profession can be found in the Companies Act, 2013. Section 247 of the Act, proverbially, gave birth to the profession. Subsequently, the Ministry of Corporate Affairs (MCA) delegated the powers and functions pertaining to Registered Valuers, to the Insolvency and Bankruptcy Board of India (IBBI).

The Valuation Examination is mandated under Section 247 read with sections 458 and 469 of the Companies Act, 2013 (18 of 2013). It is one of the mandatory conditions for registration as a Registered Valuer with the Insolvency and Bankruptcy Board of India.

The importance of recognition of valuation as an important economic function necessary when the country transitions to a fully formalized economy, with efficient capital markets and tax systems cannot be overstated.

As per the latest (2020) syllabus for the valuer’s examination (https://ibbi.gov.in/SFAsyllabuswef01062020.pdf), core valuation topics are covered under three broad headings 1) Overview of valuation 2) Valuation approaches and 3) Valuation application. Together these topics account for 42% of the IBBI examination syllabus.

It is easy to see why this is so important for your success in the valuer examination. In addition to the above three heading areas there is one heading called Case Studies, accounting for 20% weightage. This covers the application of valuation techniques covered in other headings. Together the total weightage is 62%. I rest my case!

At the core of the valuer’s professional tasks is the knowledge and application of valuation techniques. Hence right so, IBBI has placed significant weightage to this in the valuer’s exam syllabus.

In this article we will delve into the basics of valuation – what is valuation? What are the processes involved in it?

Cambridge Dictionary defines valuation as “the act of deciding how much money something might be sold for or the amount of money decided on” or “the act of saying how much something is worth”.

In finance, valuation is the analytical process of calculating the worth or value of an asset or liability (securities, bonds, stocks, loans, etc.) in a point in time, adjusted by the key components, and relative to the present. In simpler words, valuation is finding the real worth of an asset or liability.

In order to accomplish this task, there are a few but key factors that should be taken in account, factors such as the assets, revenue, cash flows, future earnings, capital structure, market value and the quality of its management.

Fundamental analysis is a technique of computing the intrinsic value of the asset. It studies all the possible factors to affect the value of the said asset. But this is only one of the methods to compute valuation. Each and every of these techniques may produce different results regarding value. Other techniques used to compute valuation is through the asset pricing model (CAPM) or dividend discount model (DDM).

CAPM is mainly used in the process of evaluating stocks. It shows the connection between systematic risk and expected return. DDM functions on the base that the value of a stock, amounts to the present value of all future dividend payments.

Valuation is primarily a quantitative process. The end game is to determine the fair value of the asset or liability in units of desired currency. Usually, the asset or liability is valued on two main bases, the absolute basis and the relative basis. The absolute basis is when the asset or liability is valued on its own, and relative basis is when the asset or liability is valued in comparison to other similar assets or liabilities.

Absolute valuation models plan to find the intrinsic value of an investment based only on the main inside key factors. Looking at fundamentals simply means you'd only look at such things as dividends, cash flow, and therefore the rate of growth for one company, and not worry about the other companies. Some examples of valuation models that are absolute in their nature are DDM, residual income model, discounted cash flow and asset-based model.

On the other hand, relative valuation models focuses on the comparison of the company in question with its peer group or other similar companies. These methods involve calculating multiples and ratios, like the price-to-earnings multiple, and comparing them to the multiples of comparable companies.

How valuation is central to economic decision making?

Valuation also plays an important role in the financial sector and is useful to investors. A valuation is often useful when trying to work out the fair value of a security, which is decided by what a buyer is willing to pay a seller, assuming both parties enter the transaction willingly.

When a security trades on an exchange, buyers and sellers determine the market price of a stock or bond. Intrinsic value as a definition does not focus on the market price of a security, but it addresses the estimated value of the security based on its future revenues. It may happen that a security is overvalued or undervalued by the market, and valuation determines if it is so. Valuation does not stop at the market price, but it takes into account more factors to estimate the true value of a security.

A simple illustration of valuation

To make it easier, let’s take a simple example. We have corporate X which price-to-earnings (P/E) ratio is higher than its peer group. From this statement we may perceive that corporate X might be overvalued. As the name may suggest, P/E is a ratio that computes how expensive is the stock price relative to the earnings per share (EPS). For example, if the P/E ratio of a stock is 5 times earnings, an analyst compares that P/E ratio with other companies in the same industry and with the ratio for the broader market in order to perceive a better valuation. Usually, the absolute valuation model is a lot harder to calculate than the relative valuation model, which is why many investors and analysts like to begin their valuation with the relative model.

Methods of Valuation

There are various ways to try to compute value of a stock. The discounted cash flow (DCF) analysis mentioned above is one method, which calculates the worth of a business or asset on the account of its earnings potential. Analysts also valuate the worth of an asset or investment using the cash inflows and outflows generated by the asset, called the DCF analysis. These cash flows are discounted into a current value employing a discount rate, which is an assumption about interest rates or a minimum rate of return assumed by the investor.

Other methods include watching past and similar transactions of company or asset purchases, or comparing a corporation with its peer group and their valuations.

The comparable company analysis may be a method that takes a look at similar companies, in size and industry, and the way they trade to work out a good value for a corporation or asset. The past transaction method looks at past transactions of comparable companies to work out an appropriate value. There's also the asset-based valuation method, which adds up all the company's asset values, assuming they were sold at fair market price, to arrive at the intrinsic value.

Sometimes doing all of the above analysis and then weighing each of them is the right way to calculate intrinsic value. Meanwhile, some methods are more appropriate for specific industries and not others. For instance, you would not use an asset-based valuation approach to valuing a consulting firm that has few assets; instead, an earnings-based approach just like the DCF would be more appropriate.

Is there a right method?

When deciding which valuation method to use to value a stock in the beginning, it is easy to become overwhelmed by the amount of valuation techniques available to investors. There are valuation methods that are fairly straightforward while others are more involved and sophisticated.

Unfortunately, there is no one method that's best fitted to every situation. Each stock is different, and every industry or sector has unique characteristics which will require multiple valuation methods. Meanwhile, different valuation methods will produce different values for the exact underlying asset or company which can lead analysts to use the technique that gives the foremost favourable output.

Hopefully this gives you an overview of the subject of valuation. The weightage of this topic for the final Insolvency and Bankruptcy Board of India valuer examination (SFA) is about 70%. One must progress topic wise. First gather an overall perspective of the topic by reading the topics covered under Overview of Valuation. Then learn the mechanics of valuation including the tools and techniques by reading Valuation Approaches.

If you are professional such as Chartered Accountant (CA), Company Secretary (CS) or Cost Accountant (CMA) you might have covered these topics in the final stage of your CA/CS/CMA examination under the paper Financial Management or Strategic Financial Management etc. The content of the IBBI valuation examination (SFA) syllabus isn’t very different.

If you are a Master's in Business Administration (MBA) with finance specialization, you might have covered these areas either under Finance or Investments. A popular book recommended for MBA students is by Ashwath Damodaran (https://tinyurl.com/y9lpbcax). A revisit to these books/notes will be helpful.

The final broad heading covered within core valuation in the valuer examination is Valuation Applications. This is a vast area with 35% weightage. The good part is a lot of theory topics here in the form of business environment or business strategy analysis. Very simple questions on Porter’s five forces or ADL matrix are asked. Generally, students from CA, CS, CMA background ignore this easy area since these words “Porter” or “ADL” don’t sound familiar, therefore they assume these to be difficult. On the contrary these are very simple theory areas. A student of MBA would attest to this. Apart from this, greater weightage is given to Bond Valuation area with a stress on time value of money, discounting etc. Overall, this isn’t a difficult section, rather there are plenty of opportunities to score easy.