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Welcome to the world of Equity research! Every now and then
whenever I come across any equity research or valuation report, I feel
puzzled that how on earth a human being did such complex analysis? What are
their assumptions? These reports haunted me a lot until I came across the blog
of Prof. Damodaran . I followed his lecture slides religiously and tried to
explore the world of valuation from Indian perspective. In the beginning I
faced lot of difficulties but as I proceeded I saw the things are not as
difficult as they seem to be. So, I got an idea to share my experience with you
and help you to understand this weird world of analysis and valuations.
Before getting into any technical details, let’s first
understand what valuation is and how can we do it from layman’s perspectives?
Let’s assume that Ram is a shopkeeper and he wants to sell his business to
third party. His shop is having a good reputation in nearby locality and is
known for quality products and services. But since his family is planning to
move to some other place, so he doesn’t have any other option then to sell his
business. Now, the question is how can he value his shop? Should he sell it
with the price equivalent to the costt of inventory he is having? (He does all
his transactions in cash so no account receivables and payables)
Many of you who are reading this blog simply tell that he should
sell his business equivalent to the cost of inventory he is having in his
stores. This sounds rational too as there is nothing wrong in selling the
business equivalent to the amount of inventory he possesses. But you are wrong
and it is here where the role of valuation comes in to the picture. How?
Simple, what is the cost of the name and fame that he gains for his shop from
his sheer hardworking? What is the cost of the guaranteed income that you will
earn by buying his shop? So, he shouldn’t sell his shop in just the amount
equivalent to the inventory rather he must calculate the cash flow that he will
generate from his shop and then discount it with the return that he is getting
from its shop to get the actual value. He can easily get the return percentage
from its past profit to calculate the true value of the firm.
Now, replace Ram’s shop with some big firm and repeat the same
thing, you will get the valuation of the firm. But here you will have to
subtract all the expenses and add depreciation, amortization etc. to get free
cash flow which you will discount with the company’s cost of capital to get the
actual value of the firm. Kindly remember that there lies lot of difference in
the valuation of the firm and the Ram’s shop as the former involves lot of
assumption and complex calculation which I will explain in my next post.
Be ready to explore the world of valuations with me from my next
post where I am going to explain the concept of discounted cash flow in Global
Context.
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