Source: BURSA MALAYSIA | Published: April 2023
Equity valuations are used by various stock market participants ranging from tiny individual investors to big institutional investors. Equity valuation may be used either directly or implicitly to make investment decisions in the equity markets.
The projected size of the global equities market is around $70 trillion, and people involved in the stock market such as professional fund managers and academic researchers might look for mispriced stocks.
Any financial asset's true worth is considered to be a reliable predictor of how that asset will perform over the long term. In stock markets, it is assumed that financial assets having a comparatively high intrinsic value will fetch a high price and those with a relatively low intrinsic value will fetch a low price.
Although there may be short-term distortions, such as when financial assets with low intrinsic value command high prices or vice versa, these distortions are anticipated to decrease over time. In the long run, a stock's intrinsic value (and hence its market price) are determined by the fundamental forces that influence that stock. Four major categories can be used to classify the factors.
- Macroscopic economic factors
- Administration of the company
- Financial stability of the company
- Profits made by the company
For Private Investors
Recent years have seen a shift in many industrialised countries away from the defined benefit model of retirement finance and toward the defined contribution model. As a result of the action, there are now more individual stock market investors.
Employers make a periodic contribution to each employee's pension account under a defined contribution system. The staff is then urged to put the money into different financial markets (most commonly government fixed-income instruments and equity market indices).
For Institutional Investors
Economic enterprises known as institutional investors pool funds and make investments in the financial markets on behalf of a number of smaller economic organisations. Private pension plans, as an illustration, pool money from millions of people and invest it in the financial markets.
Compared to individual investors, institutional investors can benefit from economies of scale and cheaper administrative costs. Hedge funds, pension funds, banks, and governments are a few examples of these investors.
Methods
There are numerous methods for carrying out equity valuation. The most well-liked techniques comprise, but are not limited to:
Comparison Strategy - The stock value of a company should be somewhat comparable to other equities in the same class. Comparing a company's equity against that of rivals or businesses operating in the same industry is required for this.
Cash Flow Discounted - The projected future cash flows made using net present value are what determine a company's equity value. This strategy works best if the business has solid data to back up its future operations estimates.
Transactions have Precedent - The equity of a company is determined by past pricing for completed M&A deals involving businesses that are similar to it. This strategy is only applicable if recently comparable firms have been appraised and/or sold.
Asset-Based Appraisal - The fair market value of a company's net assets is used to calculate its equity value. Due to the emphasis on ongoing liabilities for assessing net asset value, this method is most frequently employed for firms that are still in business.
Book-Value Method - The equity value of a corporation is calculated using its past acquisition cost. This approach is only appropriate for businesses with slow growth that may have just undergone an acquisition.
Factors to Take into Consideration
Different people follow equity valuation in different ways. As a result, there isn't a pre-established conventional procedure. Instead, four or five broad kinds of procedures might be used to value equity. Although the methods may vary, the goals remain constant. A person doing an equity valuation might have to take these factors into consideration in some way:
Recognize the Market Dynamics and the Sector - No business runs in a vacuum. As a result, the performance of any firm is influenced by both the performance of the industry in which it operates and the performance of the overall economy. Therefore, it is necessary to take into account the macroeconomic elements before attempting to value a corporation. The foundation for an accurate value is a relatively accurate estimate of these parameters.
Make an Accurate Performance Estimation for the Business - A projection cannot be made well by only extrapolating the company's financial statements from the present. A solid projection considers how the company might alter its production scale in the near future. Then, it also considers how adjustments to this scale might impact the expenses. Sales and costs do not fluctuate linearly. An analyst would need in-depth knowledge of the company's operations to produce an accurate forecast.
Choose the Best Valuation Model - Valuation is more of an art than a science. There are numerous available valuation models. Additionally, not every one of these valuation models necessarily yields the same result. Therefore, it is the analyst's responsibility to comprehend which model, given the kind and calibre of the accessible data may be most appropriate.
Make a Valuation Determination Based on the Forecast - The next stage is to use the valuation model to calculate an exact number that, in the analyst's opinion, captures the value of the company. It could be a single anticipated value or a range. Investors appreciate a range because it makes it apparent what their lower and higher bidder limits should be.
Depending on the Appraisal, Take Appropriate Action - Finally, depending on the current market price and what the study indicates is the intrinsic value of the company, the analyst might make a buy, sell, or hold recommendation.
Thus, equity valuation is a time-consuming, arbitrary, and complex procedure. The rewards are significant for those who do succeed in mastering this skill, though.
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