By Eli Levi, Business Editor
Investment bankers are, in many respects, glorified advisors. Their advice is primarily based on the way they value different companies, but how do you value a company?
One valuation method is known as intrinsic valuation, which values the future cash flows of the company. In almost all circumstances, this is correlated with how much a company should be worth. The tough part is figuring out how much the company will produce in the future and how much those future dollars are worth today. After all, as everyone in finance knows, a sum of money now is worth more than the same sum of money in the future. To accurately predict cash flows and the value of future dollars, investment bankers must learn to effectively use what is known as a DCF (Discounted Cash Flow Analysis) model, where they make assumptions about the growth rates of the company’s cash flows, project those cash flows into the distant future, and then discount those future cash flows back to their present value. In other words, a company’s monetary generation potential determines how investment bankers view its value in the present time.
The other method of valuing a company is through relative valuation. Two examples of this would be public company comparisons or market comparisons. Neither value the company itself, but instead value it based on what other companies in the same sector are worth. A common figure to compare is the price to earnings per share (p/e). Earnings per share is the net income of the company divided by the number of outstanding shares of said company, and the p/e ratio is the price of the stock divided by the earnings per share. The p/e ratio is useful to investors because it allows investors to compare apples to apples. The price of the stock means nothing alone. For example, if the stock price was $1,000, but there were only one hundred shares outstanding (giving the company a value of $100,000) compared to a company with a stock price of $1 but with $1,000,000 worth of shares outstanding (giving the company a value of $1,000,000), the second company is worth 10x more even though its stock price is 100x less. The p/e ratio allows investors to compare companies relative to their net income.
There are two ways to think about how to value a company: intrinsic and relative. Intrinsic value evaluates a company based on what it will produce in the future, whereas relative valuation examines the company based on what it is worth to other similar companies. Valuation is an art, not a science. When evaluating a company, there is no one way to ensure accuracy.