When it comes to investing, valuing a company is an extremely important step, and making an accurate valuation is a task that tests the investor's acumen.

About Valuation and Common Valuation Methods

Company valuation methods are generally divided into two categories: one is relative valuation methods, characterized by the primary use of multiplier methods, which are relatively simple, such as P/E valuation, P/B valuation, EV/EBITDA valuation, PEG valuation, price-to-sales ratio valuation, EV/sales revenue valuation, RNAV valuation; the other is absolute valuation methods, characterized by the primary use of discounting methods, such as the dividend discount model, free cash flow model, etc.

I. The Business Model of a Company Determines the Valuation Model

1. Capital-intensive companies (such as traditional manufacturing), primarily use net asset valuation methods, with profit valuation methods as a secondary approach.

2. Asset-light companies (such as service industries), primarily use profit valuation methods, with net asset valuation methods as a secondary approach.

3. Internet companies, consider user numbers, click-through rates, and market share as long-term considerations, with a focus on price-to-sales ratio.

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4. Emerging industries and high-tech companies, consider market share as a long-term consideration, with a focus on price-to-sales ratio.

II. Market Capitalization and Enterprise Value

Regardless of which valuation method is used, market capitalization is the most effective reference.

Market capitalization is calculated by multiplying the company's share price by the number of outstanding shares. It reflects the total value of a company's equity and is often used as a benchmark for comparing the size of different companies. Enterprise value, on the other hand, is a measure of a company's total value, taking into account not only its equity but also its debt and other liabilities. It is calculated as the market capitalization plus debt, minority interest, and preferred shares, minus cash and cash equivalents. Both market capitalization and enterprise value are crucial metrics in the valuation process, as they provide insights into the market's perception of a company's worth and its potential for future growth.① The significance of market value is not equivalent to stock price

Market value = Stock price × Total number of shares

Market value is regarded as the market investors' recognition of a company's value, focusing on the relative "magnitude" rather than the absolute value. In the international market, a market value of 10 billion USD is often used as a benchmark for excellent mature large enterprises, while a market value of 50 billion USD is a benchmark for international mega-corporations, and a market value of a trillion signifies the supreme status of a company. The significance of market value lies in the comparison of magnitudes, not in the absolute values.

② Market value comparison

Since market value reflects the magnitude of a company, comparing the magnitudes of similar companies is very meaningful in the market.

[For example] Both are film production and distribution companies, but China's Huayi Brothers has a market value of 41.9 billion RMB, which is approximately 6.8 billion USD, while the American DreamWorks Animation (DWA) has a market value of 2.5 billion USD. Additionally, Huayi Brothers' revenue in 2012 was 1.3 billion RMB (212 million USD), while DreamWorks' revenue for the same period was 213 million USD.

These two companies have revenues in the same magnitude, but their market value magnitudes are not at the same level. This suggests that Huayi Brothers may be significantly overvalued. Of course, high valuation reflects the market's expected pricing, and overvaluation or undervaluation does not constitute a basis for buying or selling, but it is a warning signal. Savvy investors can adopt hedging arbitrage strategies.

Common market value comparison benchmarks:

Cross-market pricing for the same stock with the same rights, comparing the market value of the same company in different markets. For example: A-share and H-share pricing comparison.

Market value pricing comparison of similar companies, comparing companies with basically the same main business. For example: comparing Sany Heavy Industry with Zoomlion.Similar business enterprise market value ratio, the main business has some similarities, it is necessary to split the business and make a comparison of the same kind. For example, compare Shanghai Jahwa with Unilever.

③ Enterprise Value

Enterprise Value = Market Value + Net Debt

The absolute value of EV is not very meaningful, it is usually combined with profit indicators to reflect the relationship between enterprise profitability, net debt, and market value. For example: the EBITDA/EV ratio is used to compare the profitability of enterprises with similar enterprise values.

III. Valuation Methods

① Market Value/Net Assets (P/B), Price-to-Book Ratio

When examining net assets, it is necessary to clarify whether there are significant items entering or leaving the financial statements. Net assets need to be deducted to reflect the real operational asset structure of the enterprise. The price-to-book ratio only makes sense in comparison, and the absolute value is meaningless.

Identify the historical lowest, highest, and average three levels of price-to-book ratio ranges for the enterprise over a relatively long period. The examination period should be at least 5 years or a complete economic cycle. If it is a newly listed enterprise, it must have at least 3 years of trading history.

Identify enterprises in the same industry with a longer trading history for comparison, and clarify the three levels of price-to-book ratio ranges.

② Market Value/Net Profit (P/E), Price-to-Earnings RatioWhen examining net profit, it is essential to clarify whether there are any significant items that affect the financial statements. Net profit should be adjusted to reflect the true net profit of the company. The price-to-earnings (P/E) ratio only makes sense when compared, as the absolute value is meaningless.

Identify the historical range of the lowest, highest, and average P/E ratios over a considerable period for the company. The examination period should be at least 5 years or one complete economic cycle. For newly listed companies, there must be at least 3 years of trading history.

Compare with companies in the same industry with a longer trading history to clarify the three-tier P/E ratio range.

③ Market Value/Sales (P/S), Price-to-Sales Ratio

Sales must be clearly defined in terms of their main composition, and any significant items that affect the financial statements should be identified. Identify the historical range of the lowest, highest, and average P/S ratios over a considerable period for the company. The examination period should be at least 5 years or one complete economic cycle. For newly listed companies, there must be at least 3 years of trading history.

Compare with companies in the same industry with a longer trading history to clarify the three-tier P/S ratio range.

④ PEG, reflecting the ratio between the P/E ratio and the net profit growth rate

PEG = P/E Ratio / Net Profit Growth Rate

It is generally believed that a ratio of 1 indicates a reasonable valuation, a ratio >1 suggests overvaluation, and a ratio <1 indicates undervaluation. This method is used only as a supplementary indicator to the P/E ratio in investment practice and does not have significant practical significance.

⑤ Benjamin Graham's Growth Stock Valuation FormulaValue = Annual Earnings × (8.5 + Expected Annual Growth Rate × 2)

In the formula, the annual earnings refer to the earnings from the most recent year, which can be replaced by TTM earnings per share (earnings from the last twelve months). The expected annual growth rate is the growth rate anticipated for the next three years. For example, if a company's TTM earnings per share is 0.3, and the expected growth rate for the next three years is 15%, then the company's stock price = 0.3 × (8.5 + 15 × 2) = 11.55 yuan. This formula has strong practical value, and the calculation results must be combined with other valuation indicators and should not be used in isolation.

The above methods should not be used in isolation and should at least be combined with two other methods for joint analysis. Their absolute values also have no practical significance. The key to valuation is comparison, especially comparison among similar companies; cross-industry comparisons are meaningless.

Three Common Misconceptions in Valuation

An investor really only needs to learn two subjects: how to understand the market and how to value. — Warren Buffett

Those who believe that a company's value is simply a few financial ratios, equal to a simple PE, PB, and then a comparison of horizontal and vertical, don't you think you are too naive?

If the value of a company could be determined so easily, then basically a high school graduate could value all companies. A person who can look up information and compare a few numbers could easily become wealthy.

In this dog-eat-dog world, being able to look up information and compare a few financial data has never been a competitive advantage, nor has it ever been a true valuation.

Value investing has four basic concepts and two important assumptions.1. Stocks are equivalent to equity, representing ownership in a business.

2. Utilize "Mr. Market" to gauge market fluctuations.

3. Since the future is uncertain, a margin of safety is necessary.

4. Through prolonged learning, one can develop their circle of competence.

These four concepts are the core ideas of value investing. Below are two important assumptions.

Assumption 1: Prices will converge towards value.

Essentially, in the U.S. stock market, the time for prices to converge towards value is 2-4 years. That is to say, if you truly find a correct bargain, purchasing something worth a dollar for fifty cents.

In the U.S. stock market, the time for this fifty cents to revert back to a dollar is 2-4 years.

If the reversion occurs in 2 years, then the annualized return is 41%.If it is a 3-year regression, then the annualized return is 26%.

If it is a 4-year regression, then the annualized return is 19%.

In fact, if value investing can be summarized in one sentence, that sentence would be: Buy something worth a dollar for fifty cents, and then ensure that the fifty cents can become a dollar within 2-4 years (catalyst).

There are many reasons why prices will gravitate towards value, such as 2-4 years being the time when many other investors also discover that this is a good investment opportunity, but the most important basis is: regression to the mean and the law of large numbers.

Assumption 2: Value is measurable (Measureable)

For investors, the measurability of value has two meanings:

a. The value itself can be detected through some clues. Value is measureable

b. You can detect the value. Value is measureable BY YOU.

So-called financial analysis, industry analysis, is essentially using clues to find the value of a company. However, many people put the cart before the horse and blindly believe in one or two analytical tools. Below are some summarized misconceptions in valuation.Myth 1: Modeling Free Cash Flow

The definition of enterprise value is deceptively simple: the value of a business is equal to the discounted present value of the free cash flows it can generate over time. However, it is important to note that this definition can only be conceptualized, not modeled.

Out of ten discounted cash flow (DCF) models based on free cash flow, at least nine are nonsense.

The reason is straightforward: almost all free cash flow DCF models require forecasting free cash flows for the next 3-5 years, followed by a "terminal value."

Firstly, unless you are forecasting for companies like Coca-Cola or American Express, predicting financial data for 3-5 years is nothing short of a joke, with very low accuracy.

Moreover, in most cases, the terminal value in the DCF model accounts for more than 50% of the stock's value within the model. Therefore, even a slight change in the terminal value can lead to a vastly different valuation. This terminal value is also highly sensitive to the discount rate; reducing the discount rate by 1% could potentially double the entire company's valuation.

The inability to model does not mean that the concept cannot be used in real life; it simply means you cannot directly calculate the valuation using the DCF model. However, you can use the model for reverse thinking, to deduce whether the current valuation level is high or low.

For example:

During the internet bubble in 1999, Microsoft's stock price peaked at around $59, corresponding to a P/E ratio of 70 times, with earnings per share of about $0.86 that year. What does this mean?Let's start by briefly explaining what free cash flow is: Free cash flow refers to the cash flow that a business can freely dispose of after meeting its short-term and long-term survival pressures.

If we were to express it in a formula, considering the business as a whole, free cash flow is equal to:

\[ \text{Free Cash Flow} = \text{CFO} - \text{FCInv} - \text{Int} \]

Where CFO stands for operating cash flow, FCInv refers to fixed capital expenditures, and Int refers to interest expenses.

Returning to the example mentioned earlier:

Suppose that 50% of the $0.86 profit is free cash flow, and the remaining 50% is necessary capital expenditures. Therefore, Microsoft's free cash flow in 1999 was $0.43. Then, we assume that Microsoft's growth rate over the next 10 years is 30%, which is an astronomical growth rate for any business to maintain for 10 consecutive years.

So, by 2009, its free cash flow for that year would be $5.93, which is 13.8 times that of 1999.

At that time, in 1999, the interest rates in the United States were between 5% and 6%, so we use a 10% discount rate for discounting. Then, we can calculate all the expected cash flows from 2000 to 2010, which are: $0.56, $0.73, $0.94, $1.23, $1.60, $2.08, $2.70, $3.51, $4.56, $5.93, respectively.

Finally, discounting the above free cash flows back at a 10% discount rate, we arrive at an astonishing figure: $12.10.That is to say, on the day in 1999 when Microsoft's stock price reached $59, the discounted value of the free cash flow for the next 10 years only accounted for 20.5% of the stock price (12.1/59). In other words, on the day the market valued Microsoft at $59, 80% of the value of Microsoft's stock price depended on the company's performance after 10 years, that is, after 2010, and the growth rate of Microsoft's free cash flow. The actual stock performance tells everything. After 2000, Microsoft's stock price has been maintained at $20-$30 until it found a new business engine - cloud computing. The above example is just to illustrate one point: discounted free cash flow is a way of thinking, not a calculation formula, and cannot be simply modeled (DCF model). Mistake 2: Simply using PE as a valuation indicator. In most cases, the PE used by most people is a useless indicator. I once heard a clerk in a copy shop asking others, I saw on xxx software that the PE of bank stocks is very low, can I buy it? If you are still simply and unrestrictedly using PE and PB today, you are basically equivalent to a passer-by in the investment world - commonly known as "chives". The PE and PB indicators have the following problems: ① There is a hard injury on the thinking level. What is a hard injury on the thinking level? That is to say, there is a hard injury in the formula level of this indicator. PE = stock price / earnings per share.If you multiply the formula by the total shares outstanding both at the top and bottom, then PE = Total Market Capitalization / Net Profit; hence, when you use PE, you are essentially contemplating the relationship between total market capitalization and net profit. This also implies that there is a fundamental flaw in the way PE is conceptualized.

This is because the value of a company is divided into two parts: shareholder value (market capitalization) and creditor value (debt). PE only takes into account the shareholder value and does not consider any creditor value.

To illustrate with an extreme example, let's assume that Company A has a market value of $100 million, an annual pre-tax profit of $100 million, a net profit of $60 million, and debt of $9.9 billion.

Although the PE ratio is 1.67 times, due to the severe debt, if you consider creditors and shareholders as a whole, the actual value of the enterprise is $10 billion (buying out both the creditors' debts and the shareholders' shares), the actual "PE" would be 166.7 times.

②EPS is highly susceptible to manipulation

The second major issue with the PE ratio is that EPS can be easily manipulated, often including many one-time profits.

What the PE ratio truly intends to express is: when I am to acquire a company, how many times the current profit am I paying for.

However, it is clear that most people have misused it. This is because the current profit may contain fraudulent issues and one-time profits. In reality, this "current profit" should specifically refer to "the operating profit that appears now and will also appear in the future."

Therefore, if you are to use PE, at the very least, you should adjust the accounts to remove all non-operating, unsustainable profits to obtain an operating sustainable profit.

If, when using PE, you are considering the company's sustainable profitability (Normalized Earning Power), then it becomes a usable ratio. This is where the complexity of investing lies, and also where it becomes interesting.③ Low PE does not necessarily mean undervalued

A low PE ratio for a company does not necessarily mean the market is wrong. It could be that the market is anticipating poor future profits for the company. For example, a company's current stock price is $10, and its EPS (Earnings Per Share) is also $10, giving it a PE ratio of 1, which seems very low.

However, perhaps the market believes that $8 of that $10 is a one-time profit, or the market thinks the company's profitability is deteriorating, earning $10 this year but possibly only $1 next year.

If the market is correct, then even though the PE ratio appears to be 1, it does not mean the company is cheap.

In this case, if you want to invest in this stock, you need to understand the market's logic and why the market might be wrong.

Myth 3: Simply using PB as a valuation metric

The PB (Price-to-Book) ratio is a very good indicator for the financial and insurance industries because most of the assets these companies hold are cash in most cases. Therefore, it may represent the degree to which a company is undervalued. Using PB to measure U.S. bank stocks is an effective indicator.

However, I believe that the most important indicator for measuring bank stocks is not PB, but rather the adjusted Return on Assets (ROA).

What the PB ratio is trying to express is: to see what proportion of the company's "net assets" the current stock price represents. If the stock price is below the net assets, "theoretically," the company is "safe."

So, the question arises, how do most people calculate "net assets"? They directly use the Book Value, and from the formula, most people use Book Value = Shareholders' Equity = Assets - Liabilities.If you calculate the Price-to-Book (PB) ratio in this way, then the PB ratio becomes a useless indicator. This is mainly because the actions of the management can directly affect the size of the equity attributable to the owners.

In the GAAP financial statements, there are four components of equity attributable to the owners:

The last one is accumulated other comprehensive income (OCI). Under U.S. accounting standards, OCI is generally recorded in the income statement, so I won't elaborate on it here.

The biggest issue with equity attributable to the owners lies in treasury stock and retained earnings. When a publicly traded company repurchases its own shares, it records these shares as treasury stock.

These treasury shares are a deduction from the equity attributable to the owners. That is to say, this item is negative.

Therefore, when a company repurchases more shares, leading to an increase in treasury stock, a larger number must be subtracted from the equity attributable to the owners, thus reducing the equity attributable to the owners.

This is also why IBM's equity attributable to the owners is so small and its return on equity (ROE) is so high. It's not because IBM is exceptional, but because IBM has repurchased a large number of shares!

You can see that the larger the dividend payout ratio of a company, the smaller its retained earnings, the smaller its equity attributable to the owners, and the larger its ROE. Conversely, the smaller the dividend payout ratio, the larger the retained earnings, the larger the equity attributable to the owners, and the larger the PB ratio.

Therefore, in the vast majority of cases, I do not use the PB ratio, do not use ROE, and do not perform DuPont analysis. It is precisely because I am very familiar with these formulas that I only use them when they are effective in a few cases.How to Value Correctly?

First and foremost, it should be stated that there is no universal valuation tool that applies to all situations in this world. Just as there is no perpetual motion machine, in the world of investment, there is no method or tool that can make everyone money.

Therefore, fundamentally, the most accurate valuation method varies for each industry. This is why it is essential to establish one's circle of competence. For instance, in the energy sector, replacement cost and a company's oil or natural gas reserves are excellent valuation methods.

Although we do not have a one-size-fits-all key, there are still some valuation tools that are clearly superior to Price-to-Earnings (PE) and Price-to-Book (PB).

1. EV/EBIT

In fact, EV/EBIT is a valuation tool that is clearly superior to PE. PE essentially equates to the company's market value divided by net profit. However, market value is only a part of the company.

EV/EBIT addresses this issue. EV stands for Enterprise Value, which takes into account not only shareholders but also creditors.

Thus, Enterprise Value = Market Value + Long-term Debt + Minority Interest - Cash. This approach views the company as a whole, thereby avoiding the issues associated with PE.Additionally, PE (Price to Earnings Ratio) does not take into account the capital structure, so often even two companies in the same industry cannot be directly compared. EBIT (Earnings Before Interest and Taxes), on the other hand, is the profit before interest and taxes, which removes the impact of the capital structure on the company's profits, thus making it more comparable.

II. Replacement Cost

Replacement cost refers to the cost that would be incurred to establish a new enterprise with the same production capacity and efficiency as the current business. This is actually the true "PB" (Price to Book Ratio).

For technology stocks, this cost is nearly incalculable, but for companies in energy, infrastructure, retail, and similar sectors, replacement cost holds significant meaning.

Suppose there are 100 competitors in the market today. Then, a shrewd businessman wants to enter this market, and he generally has two options:

1. Establish his own business and compete with these 100 rivals.

2. Acquire a company from among these 100 competing enterprises to enter the market.

So, under what circumstances would option 1 be used, and under what circumstances would option 2 be used? It's actually very simple: when the market value of the companies in the current market is less than the replacement cost, the astute businessman would choose to acquire. When the market value of the companies in the current market is greater than the replacement cost, the businessman would choose to establish his own business.

From an industry perspective, if an industry is undervalued in a cyclical downturn, and its overall value is less than its replacement cost, this means that it is difficult for new entrants to enter the industry.

In the oil refinery industry, one of the most important core indicators of whether an oil refinery was bought at a high or low price is the replacement cost. The replacement cost of an oil refinery is, in fact, the expenditure required to dismantle and rebuild an identical refinery.The general reconstruction cost is divided into: Greenfield Replacement Cost and Brownfield Replacement Cost.

Greenfield Replacement Cost refers to the cost of rebuilding equipment on land that has not been contaminated. Generally, Greenfield Replacement Cost includes expensive environmental protection expenses. Brownfield Replacement Cost refers to the cost of rebuilding equipment in places where contamination has already occurred.

The enterprise value is equal to the discounted value of the free cash flow it can generate over time. This definition is close to perfect. However, this definition is almost impossible to model, and essentially 95% of DCF models are nonsense.

In the next life, you will not see Li Ka-shing, Wang Jianlin, or Buffett asking two experts to make two free cash flow discount models to see how much a company is worth.

When they judge how much a company is worth, they consider three things:

1. How much is the current asset value of this company.

2. What is the normalized profit of the company now? If I operate it, which costs can I cut, and how much can I increase the normalized profit?

3. How much growth potential does the company still have?

PB is essentially an indicator created to address the first question. To more realistically think about how much an enterprise's asset value is worth, you may need to carefully go through the balance sheet, and you may need to look at the reconstruction cost, etc.

PE is essentially an indicator thought out to solve the second question, but like PB, this indicator is also abused. There are many one-time profits and a large amount of non-operating profits in some listed companies. When you really want to buy the company completely, you will only consider the sustainable normalized profit.Additionally, PE also overlooks a company's capital structure, as it does not take into account any debt situation.