When making an investment based upon fundamental factors, we first crunch numbers to create ratios that help in our decision making. From there, we crunch more numbers to determine fair value estimates.
Depending upon the analyst’s style and the industry being examined, many different valuation models can be deployed. In future articles, we will discuss each of these models. Here we focus on factors common to all valuation approaches. By understanding these five characteristics, we increase the odds that our results are accurate and applicable. If we understand which factors will influence the fair value estimate, we begin our researching looking for the proper data. The factors are:
1. Rewards growth – The denominator of every valuation model is calculated as the difference between expected growth and the risk of the company. By having expected growth in the denominator, companies are rewarded for high growth rates.
2. Punishes risk – Just as a high growth rate will lead to higher investment multiples, high risk results in lower multiples and lower prices. By allowing for this adjustment factor, the models are paying for what is good and punishing what is bad.
3. Cash flow is king – The value of all assets is based on the cash flow the company can generate. Whether using book value, sales, earnings, or dividends, higher total cash flow results in higher values.
4. Garbage in, garbage out – As with ratio analysis, the final calculation is sensitive to the inputs used. With valuation models, growth rates that are too high or risk factors that are too low will result in useless results.
5. Standardization – Valuation results account for differences in risk factors and growth rates, allowing us to standardize our assessment across various companies. By focusing on the results instead of the metrics used, we can determine which companies are the most attractive investments.
Implementing valuation models is the final step in making investment decisions. Understand these common characteristics and you will increase the odds of properly implementing your investment decisions.