Module for Investors
Advanced Fundamental Analysis - Valuation
Final valuation process: step by step breakdown
Finally, we’ve come to the end of this module. It was quite a mixed ride with both theoretical and practical aspects, wasn’t it? We saw how valuation is the end game of fundamental analysis and took an in depth look at the most popularly used valuation technique - the DCF method.
In addition to this, we also learnt that valuation is not only about punching in numbers and calculations. It also includes qualitative aspects. And lastly, we concluded with how you can build your own DCF valuation model and the various valuation ratios that investors typically use for making investment decisions.
Having learnt everything else in connection with the concept of valuation, it is time for us to delve into the process that you’ll need to follow to successfully carry out a valuation exercise on a company. So, without any further delay, let’s jump right in.
The valuation process
The entire valuation process comprises 7 major steps. We’ll adopt a step-by-step approach, to make it easier for you to understand and appreciate the process.
Step 1: Identification of the company
As you’ve already seen before in this module, the entire process of valuation can be quite exhausting and time consuming. And so, it is of utmost importance to identify the right company beforehand. To do that, you’ll have to analyse the company fundamentally. This involves reading through its annual report, its financial statements, and calculating the various key ratios. Once you’ve done the whole exercise and find that the company is fundamentally strong, only then should you go about the valuation process.
Step 2: Do your due diligence and look outside the annual report
Once you’ve chosen the company for your valuation process, the next logical step would be to conduct a due diligence exercise. Here, you need to focus on the qualitative aspects of the company such as corporate governance and accounting policies. While you’re at it, it is also a good idea to focus on the external factors that can affect the valuation of the company. This not only gives you some much-needed information about the company and the industry it operates in, but also makes it easier for you to value the company.
Step 3: Pick a valuation method according to the nature of the company
If done right, the previous step would have given you a much better understanding of the nature of the company. You can use this to your advantage. Now that you’re aware of everything there is to know about the company, your next step would be to choose the right valuation methodology in accordance with its nature. For instance, if the company pays dividends regularly and consistently, it might be a good idea to adopt the Dividend Discount Model (DDM). For other companies, you could use the Discounted Cash Flow (DCF) method or the asset-based valuation method.
Step 4: Get all the data points needed for the valuation process
Now that you’ve chosen the valuation method that you’re about to use, the next logical step would be to consolidate all of the relevant data points necessary for the process. For instance, if you’re using the DCF method of valuation, you would need to compile the following data points.
- Tax rate
- Depreciation and amortisation
- Changes in the working capital
- Capital expenditure
- The total value of debt
By compiling all of the data points needed for the valuation in one place, you can make the process smooth and save a lot of time, since you don’t have to keep cross referencing.
Step 5: Get all your assumptions done
The DCF method as well as the DDM method of valuation require you to make certain assumptions. So, once you’ve compiled all the quantified data of the company, the next step is to get all of your assumptions in order. For instance, the DCF method requires you to assume the forecasting period, the discount rate, and the terminal growth rate.
And the DDM method requires you to make assumptions with regard to the expected dividend for the upcoming period, the estimated cost of equity, and the dividend growth rate. Listing all of these assumptions sort of sets the stage for the valuation exercise. It gives you a great deal of clarity and helps you stay within reasonable boundaries when valuing the stock.
When making assumptions, it is always a good idea to adopt a conservative stance. Being overly optimistic during such an important step can end up giving you skewed results. And considering the volatile nature of the stock markets, conservative is the right way to go.
Step 6: Perform the valuation exercise
Now that the relevant data is compiled and the assumptions are all done, it is time to move on to the main part of our valuation process. This involves substitution of all the data into the pertinent formulas to calculate the value of the stock of a company. For instance, if you’re using the DCF method, this step would involve the calculation of free cash flows, determination of the terminal value, discounting of the future cash flows and the terminal value, and finally the calculation of the value of equity of the company.
Step 7: Account for errors and deviations
Since most valuation methods require you to make a lot of assumptions, it may not always be possible to predict the future growth of a company accurately. Therefore, it is essential to give room for the errors and deviations that may inevitably creep in. And to minimise the errors and deviations in your valuation method, it is a good idea to perform the exercise multiple times with varied assumptions and growth rates.
For instance, if you’re using either the DCF or the DDM method of valuation, you could perform exercise with three to four different assumptions. Once you’ve performed multiple instances of valuation, you could then average out the results. This will likely produce more accurate and reliable results, which you can use to base your trading decisions.
And, that’s a wrap on this module! In the next module, we’ll move onto another exciting concept that deals with how a company gets listed in the stock exchanges - the Initial Public Offering (IPO). Till then, keep reading and keep learning.
A quick recap
- The entire valuation process comprises 7 major steps.
- It is of utmost importance to identify the right company beforehand.
- Once you’ve chosen the company for your valuation process, the next logical step would be to conduct a due diligence exercise.
- The next step would be to choose the right valuation methodology in accordance with the nature of the company.
- Once you’ve chosen the valuation method that you’re about to use, the next logical step would be to consolidate all of the relevant data points necessary for the process.
- When you’ve compiled all the quantified data of the company, the next step is to get all of your assumptions in order.
- The next step involves substitution of all the data into the pertinent formulas to calculate the value of the stock of a company.
- Since most valuation methods require you to make a lot of assumptions, it may not always be possible to predict the future growth of a company accurately. Therefore, it is essential to finally give room for the errors and deviations that may inevitably creep in.