Valuations are an important aspect of investing, as they indicate whether shares are cheap or expensive. Savvy investors would compare companies across an industry to assess which are the best ones, by comparing aspects such as return on equity, margins and free-cash-flow yield. The company which has the best financial and operational characteristics and is trading at the most reasonable valuation would be selected for investment.
As we sift through dozens of companies to determine which provides the best value, the idea of a valuation template sounds tempting. A template is used to quickly provide us with the fair values of companies – all the investor needs to do is to input his assumptions and numbers into it. This would save valuable time and effort if the template was set up properly. Depending on how detailed the template is, it would also be able to provide a range of fair values for a company and to provide a quick determination as to whether a company is cheap or expensive.
Creating a template
There are many templates available for download from the internet, whether it is for discounted cash flow, dividend discount model or other types of financial models. Investors who prefer simpler templates may also create their own and stick to simpler valuation metrics such as price-to-earnings or price-to-book.
Using the template
Spreadsheet templates normally come loaded with formulae and simply require investors to key in the key assumptions into the right cells. These models would generate a fair value for the company based on the assumptions and growth rates used. The useful thing about the models is that investors can simulate different scenarios for growth rates and other metrics, and also test out how sensitive the fair values are to changes in specific assumptions.
Limitations of templates
While such valuation templates may be able to churn out different combinations of fair values for different types of assumptions, investors need to know their limitations as well. Spreadsheets work based on “garbage in, garbage out”, meaning that if the assumptions used are erroneous or flawed, then the spreadsheet will also spit out nonsense.
Investors who rely on fair values resulting from flawed assumptions put themselves at risk of investing based purely on what a spreadsheet tells them, and allowing this to override basic common sense is a risk to watch out for.
The Foolish bottom line
While templates are easily available for download and serve a good purpose to investors, they also have inherent limitations. Investors need to identify which template is best suited for a certain type of company, and their assumptions on growth rates and financial metrics have to be fairly accurate and realistic as well.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.