Why Devaluing the Currency is a Bad Idea?
The European economy is facing a significant downturn. There is a looming financial crisis in Europe which has been caused by excessive borrowing in the past. However, it is unlikely that this borrowing will stop in the near future. This is because the immigrant crisis in Europe is draining its resources making borrowing inevitable. In […]
The Anatomy of Commodity Indices
Movements in the stock markets are easy to track. This is because instead of looking at the movements in the price of several different stocks, investors can simply look at the movement in the underlying index. This is where the concept of index is derived from. It provides a pulse of the market wherein one […]
Issues in Determining Discount Rate for Valuation of Sports Franchises
In the previous article, we have already understood the method used for deriving the discount rate which is used while deriving the valuation of sports franchises. The method was described in detail. However, even though theoretically, there is a method available to derive the discount rate, there are several practical issues that make it difficult […]
Calculating Free Cash Flow to Equity
We studied the different methods to calculate the free cash flow to the firm (FCFF) in the previous articles. In this article, we will learn about how to derive free cash flow to equity (FCFE). Here too there are multiple methods involved. However, since we already have a background in calculating cash flows, we need […]
Managing Revenue Risks in an Infrastructure Project
Equity and debt are the most commonly used sources of funding when it comes to infrastructure financing. However, in many cases, revenue is also an important source of funding. This is because, in many cases, revenue from previous phases of the project is used to fund the construction of newer phases of the project, thereby […]
Estimating the value of equity stock of a company is not an easy proposition. This is because while estimating the stock price, all the data required to be used in the formula is not easily available. This is because the data is subjective.
It is really the analysts call on what they believe about the company, its future and based on it what numbers they input in the formula.
Also, slightly different numbers used in the formula give vastly different results. Hence, an analyst must have a strong basis to use any number as an input to the stock valuation formula.
Here are some of the common assumptions that will have to be made by the analyst during the stock valuation exercise:
As we learned in the previous article that stock valuation happens in two stages. The first stage is the horizon period for which exact cash flows are estimated.
Beyond the horizon period, the stock is considered to be a growing perpetuity and its value is estimated. But the question is “How big or small should the horizon period be and why?” We need to understand that the answer to this is not factual or based in proof.
Rather, the answer is based on subjectivity and convention. It is therefore entirely up to the analyst to decide what the horizon period should be?
An investor, however must be aware that changing the horizon period has massive effects on the stock valuation and must therefore watch out for the same.
After the horizon period is over, the stock is considered to be a growing perpetuity. This means that it will continue growing at a constant rate for the rest of its perpetual life.
This rate must be less than the required rate of return or else the answer we will receive will be infinite since it will no longer be a decreasing infinite series.
But, then what should that constant rate of growth be? This is again a matter of great subjectivity. Once again the analyst has a high level of discretion in this decision.
Also, this assumption is extremely important because the value of the perpetuity accounts for almost two thirds of the stock price in most cases.
A wrong assumption here can therefore give a significantly higher or lower stock price.
Apart from the expected returns to be realized from the venture, there is also a great deal of subjectivity regarding the riskiness that is involved in each case. It is obviously difficult to compare the riskiness across industries and across companies.
It is for this reason that estimating the cost of capital becomes relatively difficult. The market is efficient in pricing risk to a large extent.
The cost of equity capital is calculated using data from the market from the past few years. But once again, the riskiness can be very different depending on whether we select data for the past 10 years or for the past 15 years. This makes it a subjective decision too!
Also, the cash flows in the horizon period are estimated based on what the analyst thinks the future looks like in the next 5 to 7 years or whatever is the chosen horizon period. But, it is important to know that these estimates rarely end up being accurate.
Consider the fact that business cycles are largely unpredictable, and so are the moves by the competition and we understand why we can’t be relatively certain even about the future in the short and medium term.
The bottom line therefore is that any stock valuation is like a building which is standing on the pillars of its assumptions.
A good investor will therefore first investigate the soundness and reasonableness of its assumptions before deciding whether or not the stock valuation is fair.
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