Throughout the financial world, one rule has always been true. The general consensus is that the value of any assets or security is exactly equal to the discounted present value of all cash flows that can be derived from it in the future. Let’s see if this also works for equity valuation later on.
Equity Valuation
In the world of finance, valuation is the process of determining the fair market value of an asset. Equity valuation is therefore the process of determining the fair market value of an equity security.
Systemic importance of equity valuation
The whole system of the stock markets is based upon the idea of equity valuation. The stock market has a wide variety of stocks to offer, and each of these stocks’ values change every minute because of the change in information that the market receives on a real time basis.
Equity valuation thus is the backbone of the modern financial system. It enables companies with sound business models to command a premium in the market. On the flip side, it ensures that companies whose fundamentals are weak will witness a decrease in their valuation.
Therefore, equity valuation enables the modern economic system to efficiently allocate the capital resources among various market participants.
Equity Valuation Process
Understanding the macroeconomic factors of the industry
No company runs on a vacuum. As such, the performance of each business is impacted by the performance of the economy in general, as well as the industry in which it runs. Before making an attempt to value a business, the macroeconomic factors must be accounted for. A reasonably accurate prediction regarding these parameters builds the base of an efficient valuation.
Make a reasonable forecast of the business’s forecast.
Mere extrapolation of the company’s current financial statements does not guarantee a good forecast. A good prediction takes into consideration the changes that may happen in the company in terms of its production in the foreseeable future. It also considers the effect of the changes in this scale on the future performance of the company. Costs and sales do not move in a linear fashion. In order to have an accurate forecast, an analyst should have intricate knowledge of the company’s business.
Choose an Appropriate Valuation Model
Valuation is less of a science and more of an art. There are various valuation models available out there. Also, al of these models do not necessarily lead to the same conclusion. Hence, it is the job of the analyst to understand which model would be the best for a given type and quality of available data.
Take action bases on the valuation
The analyst has to give a buy, sell, or hold recommendation based on the current market value of the equity and the intrinsic value of the company according to his or her analysis.
The process of equity valuation is obviously a lengthy undertaking. It’s also subjective and difficult to understand. However, for those who are already masters of this art, the benefits and rewards are quite enormous.
