The objective of stock valuation is to determine whether the stock is relatively undervalued or overvalued to serve as the basis of investment decisions to buy and sell. Because of the number of factors to be taken into account, there is no single method of valuation that can be used and that the selection of methods will depend on the information that is available and the purpose for which the valuation is going to be used… It is fair to say that the use of cash flows is appropriate in many situations. For instance, companies in businesses such as telecommunications or cable TV involve large startup capital expenditure and these companies and therefore have high amortization costs. This often results in these companies reporting losses when in fact they have a healthy cash generation from operations.
Seasoned investors use cash flow as one basis of valuing these companies. Cash flow is also commonly used in venture capital because a venture capitalist is essentially buying a piece of the future of the company. The focus on future cash generation is critical to concluding whether the company can continue to fuel its business growth. The foundation of cash flow techniques for valuation is to estimate the value of the company by its potential to generate surplus cash in the future. The present value of each stream of the future cash flow is established by discounting at an appropriate rate and the sum of these present values represents the present value of the company. This ensures that the investor continues to be focused on the future prospects and growth of the company.
In making the calculations, it is essential to produce assumptions that are as realistic as possible so that the result is not highly distorted. This requires a lot of research and a good understanding of the company, its business and the industry in which it operates. The first step is to create a forecast of the company’s future operations without assuming any form of debt. Because debt can distort the valuation, interest is completely excluded from the calculations. The more care that is taken in preparing a forecast, the more reliable the valuation is likely to be.
The next step is to calculate the future cash flows whether they are negative or positive. You will also need to establish a terminal value for the company at the end of the period that you are considering. It is highly unrealistic to establish this value for a period of more than five years because of the inherent uncertainties. However if this figure is not taken into account, the underlying assumption will become one that the company is going out of business at the end of the period. This is not the case in real life where it is a safe assumption that the company is going to exist in perpetuity.
The final step is to determine the discount rate that you are going to use. This factor should also be adjusted for the risk of the investment because the higher the chosen rate, the lower the valuation. Very often, the rate that is chosen is the way to the weighted average cost of capital.