Have you ever thought about how financial managers decide which project to invest in or not? Or maybe you were in a situation in which you had to decide whether or not to invest in a project. Well, the most common rule that people are using is called the net present value rule. Or if we have projects, they typically generate benefits and costs, and what the decision rule does, is compare the present values of the benefits and costs. Aren't the benefits and the costs typically positive or negative cash flows. So what we need to do is we need to compute the present value of these positive and negative cash flows, we need to sum those present values, and then we have the so-called net present value of an investment product. And then the net present value rule states that we should invest in projects that have a positive net present value and we should not invest in projects that have a negative net present value.
Today, when everyone wants to enter investing in the stock market, they want to put the minimum money and get the most profit. In reality, it's not working as well. When somebody wants to invest in a company, they need to take 2 factors, time and risk. For example, 100$ in 10 years is not worth the same to you as 100$ tomorrow. Similarly, the bank promising 100$ to you next month is not worth the same to you as the same promise coming from this friend of yours who owes money to about everyone he knows...
So, how are you can earn like Banks and more than?!
Firstly, you need to understand that the banks/firms have gained access to many investors that may be willing to lend or invest money in them so that they can undertake new and hopefully value-generating projects. In easy words, To raise capital to finance projects.
But how can you do the same as the firms? You need to see the 3 ways to manage risk through Financial Markets as they do. By diversifying the investments, diversification = investors reduce the overall risk of their portfolios. By purchasing derivative products, insurance (through derivative products) = investors can hedge their portfolios against particular events. Through securitization = one combines different financial assets and sells parts of this combination (some parts bearing more risk than others) to different investors, thereby transferring the risks of the initial assets.
Secondly, The firms use a discounting mechanism that is used in finance to estimate today's value of an amount of money to be received in the future.
What do I mean? I mean that for putting some amount of money you calculate the realistic profit you can get. Let's see an example: "How much am I ready to pay to receive 100$ in one year?". The amount you would pay is probably smaller than 100$, right? Suppose the promise of receiving 100$ in one year is worth 80$ today to you. Then your (yearly) discount rate is 25%. Indeed, by the mechanism of discounting (i.e. going backward in time): 100/(1+25%) = 80$. Or equivalently, by the mechanism of compounding (i.e. going forward in time): 80 * (1+25%) = 100$.
So, which discount mechanism do the firms use? It's called Discounted cash flow method. So how does this method work? So you can think of a firm having productive assets that generate future cash flows for this firm. Now, similar to a net present value analysis we need to compute the present value of those future cash flows. And once we compute all the present values of the future cash flows that the firm generates, and we sum those present values we get the firm value or enterprise value. If you're interested in the market value of equity we need to subtract the firm's debt and we have the market value of equity. Now let's get more specific about those different steps. So what type of cash flows do we need? Well, we need the so-called free cash flows, these are the cash flows that are available to all investors of the firm, both debt and equity holders. And what we need to do is we need to forecast those free cash flows over an explicit forecast horizon of N years. Now in practice, this is going to be mostly between four and seven years, depending on the industry. Well, what happens beyond the explicit forecast horizon because we know that forms exist for a longer time than just five years. Well, for horizons that are further in the future, we need to make a simplifying assumption because these casuals are very difficult to estimate. And the typical assumption that we would make is that this future cash flow that is further away in the future, they're growing at a constant rate. Let's call it the rate g. And once we make this assumption, we can then compute a terminal value with a simple formula. Also, we call the 'Vn" the terminal value of those free cash flows that occur beyond the explicit forecast horizon. And what we do is we take the last forecasted free cash flow, we gross it up by one period using this constant growth rate. And then we divide it by the difference between the cost of capital and the growth rate.
Now, what type of discount rate do we need in this type of analysis? Well, we need a so-called, weighted average cost of capital, which represent the average cost of capital to all investors in the firm, both equity and debt holders. It also represents the expected returns of investors that are investing in the firm's securities. Once we have those ingredients, we can then easily compute the value of the firm. Or more specifically, the price of one share. We can compute the present value of those free cash flows by discounting those cash flows and also discounting the terminal value, which will give us the firm value, or enterprise value. Once we have the enterprise value, we again have to subtract the value of debt, divide by the number of shares outstanding, and then we get the price of one share. We have just implemented the very simple discounted cash flow analysis.
After we found the Price of one share, we use the NPV (Net Present Value) rule.
NPV is a financial metric that seeks to capture the total value of a potential investment opportunity. How does the NPV rule work? A project/investment typically generates benefits and costs that are represented by positive and negative cash flows. The NPV of a project or investment is the difference between the present value (PV) of its positive and negative cash flows.
How does the NPV rule work?
NPV = PV (Benefits) - PV (Costs) {In stocks you take for benefits the stock price that you found on previous calculations and for costs would the price of a stock at this moment).
NPV = PV (All project cash flows)
Most importantly the NPV rule states that we:
- invest in projects with a positive NPV
- do not invest in projects with negative NPV
We are indifferent when the project has an NPV of zero.
Well, all this discount mechanism, is only the first way for shareholders to calculate their Price of share and suitable their stocks if they Undervalue or Overvalued.
Let's look at a second way we can value shareholder's equity. And this is the so-called valuation by multiples. So based on multiples. So the idea of this approach is that assets that generate identical cash flows, must have the same price. So what we do is be for the price of the company we're interested in based on the price or based on the value of comparable firms that we observe in the market. So we can proceed in three steps. First, we need to find a set of comparable firms. We need to compute a ratio of market value to earnings and then we can infer the value of the firm we're interested in.
So there are other multiples that people are using, the most commonly used multiples are the price-earnings ratio. Then the enterprise to EBITDA multiple, enterprise value to our EBIT multiple, enterprise value to sales, etc. Depending on the industries people have come up with many more multiples.
Now how do we choose a good multiple? Well, we should typically take multiples that are operating in the same industry to make sure that I have a similar operating risk. And we should also try to take firms that are in a similar stage of development, meaning that they have the same expected growth rate. In addition, if you want to use the price-earnings ratio, we should also make sure that the firms have a similar financial risk.
Shareholders
How to value Shareholders' value equity:
After we understand how to calculate and understand the financials of the company, it's time to understand what is a share of the company. Before it, you need to understand what is shareholder's equity. Take a look at for example a firm. A firm's equity is the value of its assets minus the value of its liabilities. It is usually split into many small chunks called "shares" that are held by different people called "shareholders". Owning shares of a company usually comes with different rights. The first one we are focusing on here is the claim you have on part of the assets of the company (i.e. if the firm were to like paid and what is left would be split between shareholders). The second one is the right to receive a part (proportional to the number of shares you have) of the dividends the company chooses to distribute. Shares of equity are what we trade on the "stock market".
Useful concepts:
Firm value or Enterprise value = we need to compute the present value of those future cash flows. And once we compute all the present values of the future cash flows that the firm generates, around all the years we forecast, we sum those present values.
The market value of equity = we need to subtract the firm's debt from the Firm value and we have the market value of equity.
Net Present Value Tool = compares the benefits and costs of the Present Value of the project/company.