How to determine the value of a company you want to invest in
Before deciding to invest a portion of your savings in a company, it is crucial to find out its real value. However, knowing where to start is not easy without prior experience. To facilitate this task, here we will describe the different methods and tools financial analysts use.
For new investors, “it can be difficult to understand if a company is doing well or not,” explained Andrés Moreno, Personal Finance Professor at Rosario University in Colombia. “However, a vast amount of information is available. Companies publish their balance sheets online, and financial institutions their analyses."”.
Intrinsic value
A good place to start is to determine the intrinsic value of a company. According to the INEAF Business School, this concept is calculated with the following formula: intrinsic value = assets - liabilities. “If the market price of an asset is lower than its calculated intrinsic value, it could indicate that the stock is overvalued and may present risks.”
Fundamental and technical analysis
Once the information has been located, the investor should focus on interpreting it. “The investor does not have to determine the valuation of the company. There are professionals who take care of this,” Andrés Moreno explained. “What you do need to do is review the summary and understand both the fundamental and technical analyses. That way, you can decide whether or not it is worth investing in a company.”
Fundamental analysis is a technical assessment that establishes the theoretical value of a company by studying its data. “Fundamental analysis looks at the company’s multiples, how sales are going, growth, its book value, EBITDA and results,” Andrés Moreno said.
Meanwhile, technical analysis studies share price movements. “It shows us what companies on the stock market are doing; if they are going up or going down,” this expert added. And it does so in relation to its past performance, identifying support and resistance levels. “The downside is that it does not usually take the company’s financial results into account, so it is best to combine both analyses.”
Company valuation methods
Analysis of a company is the foundation for various business valuation methods. The following are some of the main methods:
Balance sheet-based methods
In this method, the value of a company is rooted in its assets, or equity, at the time of analysis. It is a traditional approach that can be carried out in several ways. “We can reference the book value (equity value), the adjusted book value (in other words, according to its market value), liquidation value (if the company sold its assets and repaid its debts) and substantial value (the investment needed to establish an identical company),” Pablo Fernández, Professor of Financial Management at IESE, explained in this report.
Balance sheet-based methods show a company’s possible value, but they are not completely accurate. “They provide the value from a static perspective that does not account for the possible future evolution of the company, the temporary value of money or other factors,”Fernández explained.
Methods based on income statement multiples
These methods estimate the potential value of a company in the market using their financial performance indicators. “Multiplication is applied to conduct a quick valuation based on profit, sales or other elements from the company’s income statement,” explained a study from the Catholic University of Argentina. The analysis is conducted on a multiple, based on the company’s future outlook, such as its growth or the size of its market. This is then compared to similar companies in the sector.
It is a useful method because it aims to integrate the company’s productivity capacity and future performance. However, the same study also warns that the results may not be precise. “Given that no two organizations are the same, this method does not fully capture the value of the company.”
Methods based on discounted cash flow
This method is based on estimates of the company’s future performance and its ability to generate money for shareholders. “It consists of predicting sales, expenses, variations in needs for working capital, investments and debt required based on the company’s financial situation, taking into account action taken by new ownership,” the consulting firm Iberdac explained. This approach promotes a dynamic view of the company and considers its evolution and cash flows. The disadvantage is that, in order to work, it requires highly precise forecasts.
These are a few of the main methods to determine the value of a company, but there are others. Experts recommend using valuations that rely on two or three methods, and ensuring that you understand the data well. “It is important to know where to look for the information,” Andrés Moreno said. “You have to understand what the most important indicators are for each company, and decide whether or not it is worth investing in it.”