The concept of valuation

How much is a company worth?

The main question in investing is "If I buy something today, how much will I realize after selling it at some time in the future?" In other words, the investor wants to know what his expected return on investment adjusted for all kinds of risks will be. A rational human being would not invest without getting (or at least guessing) an answer to this question.

Clearly, the objective of estimating future gain can be split into two parts: 1) what is the expected (or promised) amount one will get and 2) what is the likelihood that the party that is obliged (as in the case of bonds, for example) to furnish the said amount in the future will, for whatever reason, renege on its obligation.

When investing in bonds and other fixed-income instruments, the process of valuation is rather straightforward, as the amount(s) of money the investor will receive and the date(s) when he will receive them are known. All what is needed to value a bond is to estimate the probability of default of the issuer, adjust future cash flows by that amount, and discount the risk-adjusted future cash flows to the present day using current interest rates (or - which in theory should amount to the same thing – use the nominal future cash flows but increase the discount factor in accordance with the level of risk of default).

For equities, however, the task is much more challenging, as stocks in general have indefinite life and the issuer is under no obligation to repurchase them at some point in the future at a predetermined price.

The company's stock price is reflective of the value of the company. Therefore, the recipe for a successful investment in stocks is to find companies whose market value will increase in the future. The task is daunting, as stock prices literally reflect everything and are set by the market forces. In a well-functioning market at any given moment the stock trades at the price at which the demand for the stock is equal to the supply, i.e. number of shares sought to be purchased at that price is equal to the number of shares sought to be sold.

Market forces aside, fundamentally, the company is worth its future cash flows that can be distributed to shareholders. This is the basic premise for equity valuation used by so-called 'value investors'. If an investor knows how much cash will be generated by a company or business, he can quite easily calculate the value of this company or business to him.

What is a company?

Generally, the main purpose of any for-profit business is to generate income for its owners. Of course, it would be nice if such income is generated ethically (not to mention legally) and the process of its generation (i.e. operations of the company) contributes to some noble course. In the latter case companies usually exploit this for marketing and position themselves almost as world saviors. When in fact, "saving the world" or, as it is more commonly put "making it a better place to live in" is just a byproduct of their main activity - generating money. There is nothing wrong with craving for money - for better or for worse, that's the foundation on which our modern capitalist society is built on.

We might have gone deeper into the discussion on merits and drawbacks of different society arrangements, but this is a subject for a different discussion and, probably, a different audience. So, let's stick to analyzing how businesses make money and how we as investors can profit from this.

Before we delve into the nitty-gritty of specific company analysis, let's conceptualize what we are dealing with here.

Categorization of production inputs

To generate revenue, the company needs to sell a product or service. But before it can be sold, the object of sale needs to be produced. Production and sale (and all related processes) require all kinds of resources (or production inputs), thatcould be categorized as follows:

  • Material assets:
    - capital assets (property, plant and equipment)
    - materials and parts (inventory)
  • Utilities (electricity, water, etc.)
  • Intellectual assets - procedures, know-how, patents, etc
  • Manpower (or labor)
  • Financial resources:
    - to realize long-term capital intensive investment projects
    - to provide working capital (to cover cash deficiency periods during the production cycle - until the receipt of funds for products/services sold)

Luckily for us, all of the above resources could be represented in monetary form, i.e. by amount of money needed to acquire and maintain them. So, in our analysis we will be dealing not with physical quantities and non-material substances, but rather with their monetary equivalents. This conversion of everything into their money equivalents is justified by our objective: we want to determine the monetary equivalent of the company itself, i.e. find out what amount of hard cash in hand is equivalent to owning the company. This process is called valuation.