How should you approach while valuing any business

Valueoperations is a brand now recognized as the specialist in valuing business rationally which are trading in the stock market. The whole idea of running Valueoperations blog is to educate investors on how to value any business and use those valuations to buy, sell or hold any stocks for their portfolio.

It really rattles me when I read or listen in commentary about PE ratio of any business is used to justify its valuations. PE ratio is a good tool only to compare businesses with its peers to find whether they are trading at cheap or expensive in that basket.

Valuation Approach

You will find millions of different ways to value any business. All of those different techniques have their own positives and negatives. So which one should we use? Or should we use more than one technique to value any business?

The most common and highly regarded technique includes discounted cash flow (DCF), sum of the parts (SOTP), quantitative ranking, company comparable, or multiples.

If you are valuing Larsen & Toubro kind conglomerate then SOTP method will be very useful method where there are different drivers from various businesses which derives its earnings. It is better to evaluate each business as a part and then sum up its valuations to come at any conclusion. However, using SOTP method to calculate, you have to make sure that you value each part of the business accurately. But if you use DCF method to calculate valuations of Larsen & Toubro then its results can be a danger in becoming too granular.

DCF

The most common and theoretically sound method is DCF. The true value of any business should represent present value of its future cash flow. However, to predict these accurately you need to make a large range of assumptions like:

  • How fast are revenues growing?
  • What will happen to margins overtime?
  • How much CAPEX will be deployed?
  • What is an appropriate weighted cost of capital (WACC)?

With each of these questions we add layer of complexity while calculating business valuations. These questions are just the tip of iceberg. For example, to predict accurately revenue growth you need to understand whether competitive environment is changing, how the industry is going, whether new verticals and horizontals are being explored, and many more like these questions.

PE ratio

We all are so busy in our day to day activities and with limited resources it becomes very difficult for many to keep track on business valuations. So easy and less granular way approach would be to use multiples, the most common of which is the P/E (Price to earnings) ratio. The ratio is straight forward calculation. However, the easiest solution is rarely best and there are often pitfalls that it encourages. For example:

  1. High growth companies have deceptively large PE multiples. For example Jubilant Foodworks when got listed in the stock market, it was trading close to 65 multiples at one stage. To put those valuations on any business Jubilant Foodworks will have to earn 65X times its earnings of that year to justify. Imagine what kind of growth it will have to deliver. Another good example would be Google. It got listed at 80 PE in 2004. Without understanding the competitive landscape and growth potential it is very hard to rationalise those valuations.
  2. Declining businesses can have inflated PE multiples. If a business will go bankrupt tomorrow, even 1X PE multiple may not be cheap
  3. PE ratios do not consider debt to equity ratio and cost of capital. Tata Steel and TCS PE ratios are pretty close, where Tata Steel reported losses and is heavily in debt business and TCS is profitable and net cash business.
  4. PE multiples only cover any one year multiples. The data point can easily get skewed when significant event have occurred in that specific year.

Conclusion

PE ratio can be used to compare if the market is pricing the business at cheap or premium to its peers. DCF calculations are very granular in nature and if adopted will need a lot of time, effort and accuracy to come to rationale valuations. Investments can’t be made in isolation by using only one method. As it is said in the finance world that, “devil is hidden in the details”

So next time if we you are buying any stock on PE ratio basis, think once again.

If you are keen to learn more about DCF calculations then click here to read more about it online.