How much is a company worth?
Discovering how much a company is worth is the starting point for Value Investing and to answer this question we have three lines of thought. The first one says that a company is worth what it produces; the second says that a company is worth what it will produce, and the last one says that a company is worth the set of goods it owns. Mix the three strands, shake them well and you will have an idea of the value of a company .
Evaluating a company is, above all, an exercise in imagination, and the evaluator must have different evaluation instruments in his tool bag, which can and should be applied in specific situations.
Valuation by Discounted Cash Flow
It is the methodology widely used in mergers and acquisitions of mature companies. This methodology creates a projection of how much the company will yield in the future and tries to compare it with what would be invested today to create such income. For example, if you know that a company will earn you R$100 a year for the next 5 years and then nothing else, how much would you be willing to pay for the company? Clearly you would be willing to invest any amount less than R$500.00; which gives us a starting point.
Image 1: Discounted Cash Flow from the shareholder's point of view -Source: Aswath Damodarn
Above we see the rationality and complexity of the method, which requires us to make a revenue projection for the coming years. Based on this projection and using other market variables, the model tries to predict the fair value of the company.
Relative Rating
It is the methodology widely used by the market due to its simplicity. If you don't know how much a company is worth, just compare it with companies in the same segment and that are at the same level. For example, you don't know how much Bradesco is worth but you know that Itaú is being traded at a price to book value (P/PV) of 1.3. Knowing this, you can imagine that Bradesco should not be traded much above nor much below this number, providing us with an interesting starting point.
Image 2: Multiples of the company Itaú Source: Yahoo Finance
Image 3: Multiples of the company Bradesco - Source: Yahoo Finance
As we see Itaú has a PVP of 1.3 while Bradesco has a PVP of 1.00, suggesting that Bradesco may be underpriced relative to Itaú.
Valuation by the Options Model
This model is widely used to evaluate new projects, companies that have not yet made a profit, and Startups . We start with what we know: the cost of creating a new venture, and try to create a probability matrix about what we don't know: sales and profit. For example, a company is yet to make a profit, but your favorite analyst gives you the following prediction: if you invest $50 in this company today, there is a 90% probability that you will make a profit of $100 next year. Would you invest in this company? Using this method, it is evident that the value of R$50 represents an opportunity, and according to this analysis, the maximum that we should be willing to invest in this endeavor would be R$90.
Image 4: Project decision making tree - Source: Aswath Damodarn
Above there is an example of the use of the options model , where a long decision tree was used to elucidate the results of a new project involving a drug from a pharmaceutical industry. As we can see, the model tries to evaluate at all times the probabilities of success and failure of the project, as well as the results obtained.
The Value Investor
In short, the valuation tools were created so that the investor can overcome the difficulty of valuing a company from the most rational point of view possible. However, it is important to emphasize that the values found by the methods presented above do not always converge to a single value, reserving the indispensable use of common sense and business sense for investors .
To think about
What is the difference between price and value?