There are many methods of valuing businesses with their respective positives and negatives. There is no single “best valuation” method because there is a large qualitative element involved in this quantitative exercise. Any valuation should apply several different methods.
Valuations are done for many reasons. To take a few common examples, you may wish to take a minority equity stake in a running business. Or, you may wish to take controlling stake, or buy a specific business division. Or, you may be interested in lending. Or, you may wish to assess a compensation package with stock options. Or, you may assess a mixed instrument like a convertible debenture. Different methods of valuation are useful in each case.
In addition, methods are constrained by the state of the business itself. Consider a start up, a loss-maker that may turnaround, a high-growth business that requires capital expenditure, a mature cash-cow. In each case, different methods must apply.
Pure asset valuations via book value or some calculation of assets minus liabilities is the most conservative. This ignores future cash-flows from a running business. An asset valuation also ignores intangible assets like brand value, synergy in mergers, etc.
An asset-based valuation may unearth under-utilised assets in bankruptcies such as Mumbai textile mills on prime real estate. It is also useful with banks and real estate developers where land banks and loan portfolios are involved.
Where available, comparison is most convenient. If there is a similar listed business, ratio analysis reveals what the market is willing to pay. Of course, the market price may be quite different from the “intrinsic value” of the business. In using comparative methods, historical performance and price-earnings multiples must be averaged over long periods.
The toughest are start ups (hence no assets and no profits), with no peers, listed or otherwise. This was the case with the entire Internet sector, for instance. In such cases, the valuer must make the best forward projections possible. Projected future cash-flows can be discounted back to net present value. Of course, DCF (discounted cash flow) involves multiple long-term assumptions and so, the errors can be huge.
DCF is universally applicable, in both profitable and unprofitable businesses. It is used by venture capitalists and Warren Buffett-followers alike. But a conservative investor will use DCF only with profit-making companies and apply higher discount rates.
Lenders use cash-flow analysis plus asset valuation. The CF indicates the ease of debt-service while asset valuation offers security. When investment in a hybrid instrument like a convertible debenture is considered, CF+ asset is also a good method.
One interesting new method is adapted option-pricing. This was developed by oil prospectors who find DCF unreliable due to high volatility of crude prices and long project gestation periods. When development starts at an oilfield, it's tough to judge what prices will be when production begins, years down the line.
Option-pricing models like Black-Scholes allow for the volatility of an underlying asset. Hence, energy exploration & production firms treat CF projections as the “underlying” with a large volatility factor plugged into an option-pricing model. The “strike price” is the total cost of development in a given timeframe and the “premium” is the initial capital expense. An option-pricing approach can also be applied to other businesses, and valuation theorists have started experimenting with this approach.
Radically different valuations arise using different models, or with different assumptions in the same model. In a recession like this, assume higher interest rates and lower price-earnings and price-book value ratios. In a boom, the interest rates are lower and the PE/ PBV multiples higher.
Most valuation approaches suggest that the Nifty is worth buying now. Price-earnings (13), price-book value (2.5), and DCF calculations at current interest rates (9%) all look favourable in historical terms. The option pricing method does suggest there's no harm in waiting. A June 2009 Nifty call at a strike of 3300c costs about 160 (approx 5%) while a 3500c is 135 (4%). Given that the underlying (spot Nifty) is at 2985, this is favourable.
If the market climbs, the call premiums are cheap. If the market falls, you can prevent loss of capital. Instead of investing 2985 right now, an investor might buy a call and invest the remainder in FDs, which fetch about 4.5% in the same timeframe and balance off premium loss in case of a downturn.