The key to successful investing lies in understanding the business, management, and the value of a stock or a company. Every asset can be valued, but some are easier to value and some are complex. I heard a lot of people getting confused with the real value of an asset and its price and there are a few myths which I would like to mention in this blog. So first let’s understand what is valuation and why it is so important.
Valuation and its Importance
Valuation is the process of determining the true value of any asset. Be it a bond, a stock, or a property. In investing your hard-earned money, it is important to make sure you are not paying for an asset more than its real value. Valuation is done by estimating the future cash flows and discounting it at an estimated rate. Thus, the exact value of an asset cannot be determined as no one knows the exact future cash flows. Investors might have different values of an identical asset because of the difference in their perception.
” A great company is not necessarily a great Investment “
Buying at the right price is really important while investing. For example, if you were to buy an iPhone worth Rs. 50,000 and the seller is giving you at Rs. 75,000. Will you buy it? Of course not and the reason is that you know the real value of the phone so you are not willing to pay more than that. The same logic applies to Investing, you are not willing to pay more than an asset’s real value but still, people buy stocks at a very high price just because they don’t know what is its real value.
Myths about valuation
Myth 1: A well researched valuation is timeless
The value calculated from any valuation model is affected by the company and also the market information. Thus, the value might change as new information comes into the picture. Valuation does not stay constant but changes in a period of time. The value of companies changes all the time, that’s why technology companies were highly valued in 1999-2000 and financial companies were highly valued in early 2008 and eventually dropped. Also, the interest rates are not constant throughout a decade. Therefore, the value today is not the same as the value it would be the next year.
Myth 2: Value of an asset is what matters; the process is unimportant
Though calculating value of an asset is important but it is also important to analyse the information you are feeding in the model. Buying just an undervalued asset is not important. The process tells us what is the appropriate price to pay for the growth, profit margins, returns on the projects, problems due to high leverage, worth of the brand, etc.
Myth 3: You won’t face a loss if you bought at right valuation
It is true that buying at right price may give you a handsome returns but it is also true that buying anything at right price can destroy your wealth. Markets are full of surprises, anything can happen in the market and due to which a good company can also go bankrupt. While buying it is also important to look not only at the valuation but also the quality, opportunities and threats of the company and the industry in which it is operating. We can take the example of current scenario, after the pandemic, many good companies came into problems and valuation decreased significantly. So there is no promise that buying at right price will provide good returns.
Myth 4: More the complex valuation model, better the valuation
It may seem obvious that a more the model is complete and complex should give better valuations. But it is not always true. As the model becomes more complex, the number of inputs increases and as these inputs are the future projections, the magnitude of error may increase. These errors compound with time and can make the model inappropriate. Warren Buffett says, invest only in those companies you understand. The reason behind it is that if you understand the business your estimations are more likely to be accurate so the valuation.
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