How To Understand The Value Of A Company

As investors, we often hear phrases such as “buy when prices are below their intrinsic value” and “buy undervalued stocks” etc…

The next obvious question is probably: “How do we determine the value of a company?”

Most people will say something like this: Buy when:

1) Price to book ratio is low

2) P/E ratio is low

3) Price to cash flow is low

4) Price is lower than the discounted cash flow/intrinsic value

Currently, CapitaLand Limited  (SGX: C31) is trading below its book value, and the Price-to-Earnings ratio (P/E) for Keppel Corporation Limited  (SGX: BN4) is below its long-term average. But are they cheap?

So what exactly is value?

Among the many definitions for value, the one that I think is both simple and meaningful goes something like this: “Value is anything that can be converted into cash”.

Generally, the value of a company can be broken down into three broad categories:

  1. Past – This is the value derived from past business activities, such as cash, land and investments.
  2. Present- This is the value derived from the current earnings of the existing business operation.
  3. Future – This value is derived from the potential growth in the earnings of the business

As investors, we must be clear which “value” we are referring to when we conduct our analysis.

Generally, value investors tend to focus on the past and the present. Growth investors tend to pay more attention to the future.

By breaking down value into the three components, we could have a clearer understanding about how to value a company.

Here is how it might work in practice.

A company with cash of S$100m and generates about S$50m in net profit per year should have a value of around S$600m. That is made up of S$100m cash plus S$50m x 10, if we assume an industry average P/E ratio of 10.

In this case, cash is the “past value” whereas the net profit is the “present value”. Notice that we have used different valuation methods to arrive at the total of S$600m. We have also kept the calculations simple by not discounting future profits to their present value.

The above is a very simple example of how this framework can help investors value a company. In my next article I will apply this framework to calculate the value of a real company.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Lawrence Nga doesn’t own shares in any companies mentioned.