How to Calculate the Valuation of a Company?

A long-term investment in the stock market is a substantial commitment. While there is no guarantee of earning capital gains from your investments, there are some measures you can take to assess the possibility of a company's value appreciating over the years. One such tried and tested measure is company valuation. It involves determining the intrinsic value of a company and comparing that value with the company's market value.

In this article, we'll take a closer look at what the valuation of a company entails, why it's necessary and how to calculate the value of any company. 

What is the Meaning of Company Valuation?

No two companies are precisely alike. From their debt levels to revenues and profitability, companies differ vastly from one another. Even two companies structured similarly and operating in the same industry can differ greatly based on the expertise of their management teams, their asset mix, customer base and more.

These differences directly affect the worth of a company and lead to the concept of company valuation. So, the valuation of a company essentially tells you how much an entity is truly worth. In other words, it is the fair value of a company and its stocks.

For any long-term investor, the valuation of a company is an important metric to look into before purchasing its stocks. This is because checking the valuation tells you whether you are paying more money or less for a company. To put it more simply, it tells you if you are buying a company's stock at a premium or a discount.

Why is it Important to Find the Valuation of a Company?

There are many reasons for long-term investors to look into the valuation of a company before making an investment decision. Some of the key reasons to find a company's true value include the following:

• Risk Assessment 

Every market-linked investment comes with the risk of underperformance, where the investment does not appreciate in value (or does not appreciate enough). Finding a company's value makes it easier to assess the risk associated with a company's stocks. An overvalued company typically has a higher risk of underperformance, while an undervalued company may likely appreciate in value over the long term. 

• Buy or Sell Decisions 

Finding the valuation of a company also helps you make buy or sell decisions more easily. Knowing the valuation can give you a better idea of how the market values a particular stock and whether the current price reflects the intrinsic value of a company accurately. If the market price is significantly higher than the true value, it may be a sign to sell the stock. However, if the market price is below the true value, a long position in the stock may be ideal.

• Return Potential 

By checking the valuation of a company, you can also find the potential returns to expect from investing in its stocks. The consensus is that undervalued companies generally have greater potential for capital appreciation because a market correction could lead to a rise in the stock’s market price — till it reflects the company's intrinsic value. Conversely, overvalued stocks may not be likely to appreciate as much. 

• Portfolio Allocation 

Another reason to look into the valuation of a company is that it can be crucial to the portfolio allocation or asset allocation process. Depending on your investment goals and risk profile, you may want to structure your portfolio in a specific manner — with distinct portions of your capital being allocated to undervalued, overvalued and fairly valued stocks. To do this, it's important to learn how to find the valuation of any company.

• Margin of Safety 

Valuation is also essential to find the Margin of Safety (MoS) of a company and its stock. This concept, proposed by Benjamin Graham, is essentially the difference between the market price of a stock and its intrinsic or true value. The lower a stock's market price is when compared to its true value, the higher the Margin of Safety is. This effectively means that the stock may be more resilient in case of market downturns. As the market price gets closer to the true value, the MoS decreases. 

How to Calculate the Valuation of any Company: Different Methods to Use

Now that you know the meaning of company valuation and how it helps, let us look into how to find the valuation of a company. Any of the following methods can be used.

1. Book Value Method or Asset Method

In this method of finding a company's value, you find its net book value or Net Asset Value (NAV) — which is calculated by using the following steps:

• Subtract the company's liabilities from its assets.
• The resulting figure gives you the shareholders' equity, from which you must subtract the value of intangible assets.
• You are then left with the value of the company's tangible assets — which is the book value considered for valuation.

This method is relatively simple and often unreliable for companies that do not have many tangible assets.

2. Market Capitalisation Method

You may already be familiar with this method of company valuation because it is widely used to classify companies as small-cap, mid-cap or large-cap entities. Here, you use the following formula to find the valuation of a company:

Market Capitalisation = Current Market Price per Share x Total Number of Outstanding Shares

The main drawback of this method is that it does factor in the debt used to finance a company's operations. 

3. Discounted Cash Flow (DCF) Method

Often considered one of the most reliable ways to value a company, this method involves estimating the future cash flows of a company and discounting them to their present value using an appropriate discount rate — which is often the Weighted Average Cost of Capital (WACC).

The formula for finding the valuation of a company using the DCF method is:

DCF = [CF1 ÷ (1 + r)¹] + CF2 ÷ (1 + r)²] + CF3 ÷ (1 + r)³] + … + CFn ÷ (1 + r)ⁿ] 

Where:

‘CF’ is the cash flow for the relevant year and ‘r’ is the discount rate used. 

4. Enterprise Value Method 

The enterprise value method factors in both debt and equity, making it a highly reliable valuation technique. The formula for calculating the enterprise value is as follows:

Enterprise Value = Total Equity + Total Debt - Cash 

The cash mentioned in the above formula refers to the funds that are not used to fund the company's operations (and hence do not directly contribute to its value).

5. Valuation Ratios 

In addition to the above methods, you can rely on different valuation ratios to assess a company's true value and compare it with its peers and with the industry or sector at large. The most commonly used valuation ratios include the following:

• Price-to-Earnings (P/E) Ratio 

The P/E ratio is calculated by dividing the current market price of a share by the Earnings per Share (EPS). What this means is that you can compare if the market prices the share accurately when compared with the earnings per share in the company. If the market price is much higher than the EPS (meaning the P/E ratio is more than 1), it means the market is willing to pay more than the EPS to buy shares in the company — pointing to overvaluation. Conversely, if the market price is below the EPS, it means the market has undervalued the stock. 

• Price-to-Book (P/B) Ratio

The price-to-book ratio compares the current market price of a company's shares to the book value per share. It tells you if the market is paying enough for the company's shares when compared with the company's net asset value. A high P/B ratio means that the market is paying a premium for the shares over and above their true worth — meaning the company is overvalued. On the other hand, if the P/B ratio is below 1, it means the market has yet to pay the true worth of the stock — meaning the company may be undervalued. 

• Price-to-Sales (P/S) Ratio

In this ratio, you check how the current market price of a company's shares stack up against the sales value per share. This comparison can tell you if the market is paying more or less per share than the company's sales warrant. A low P/S ratio may be a sign that the stock is undervalued because the market is paying less per share than the sales earned per unit of shareholdings. However, if the P/S ratio is very high, it may be a sign of overvaluation because the market is currently paying a lot more per share than the sales earned per unit held. 

Conclusion 

This sums up the nuances of what company valuation is and why it is important for long-term investments. Additionally, you also now know how to find the valuation of a company using the different methods explained above. Depending on the information available and the goal of your investments, you can use any one method or a combination of different methods to find a company's true value.

If you are looking for a one-stop solution to help you with company valuation, the Motilal Oswal Research 360 platform may be just what you need. On this platform, you can find various metrics and key details of all listed companies to make valuation easier.