4.1 Market Methods

Welcome back to Career Readiness sponsored by UCI Extension Programs. This is the course on Finance for Non-Financial Professionals. And if you’ve made it this far, you are now in module 4. In module 4, we’re going to be looking at valuation. We’re bringing finance now to the very end of the cycle of the financial equation. We’ve looked at revenue, we’ve looked at costing to get to price. So now we can actually look at income equals revenue minus cost. Income, or in other words, the value of something. The value of something is the revenue minus the cost. So whether we’re looking at an investments and want to actually invest into a security or more likely we’re often looking at companies, what is a company worth? What is a product worth? What is a project worth? I remember my very first lesson in valuation at an extremely young age. I must have been about five or six. In my house, we had a lot of antiques, I come from a long line of antique collectors and I looked at a particular antique and I asked my father, and I said, dad what is that worth? And he said whatever someone will pay for it. I said come on dad, what’s it worth? He said really, it’s worth what someone will pay for it. And so I said well what will someone pay for it? And he said well that’s up to the person. And my father left me very frustrated. In fact, so frustrated that I remembered that my entire life growing up when it was still meaningless and just a frustrating experience, until I finally went in to the business world and I actually started buying and selling myself. And I started to realize what my father was saying. That yes, many things, most things don’t have an inherent, intrinsic value. What are they worth? They’re worth what someone will pay for it. Thus the success of eBay. eBay can go out there and find the person who will pay the most. So this is finance, and this is what we’re doing. What is someone willing to pay for something? What is it worth? Well, because this can have subjective elements to it, if you ask ten different firms to evaluate a company, or a project, or a business, you’re often gonna get ten different answers. So what is something worth? How do we do this? Well, there’s a few different ways we have of valuating things in finance. In fact, there’s hundreds of ways we have of doing it. But there’s really three primary methods that we use to valuate a business, a project, a proposal. And one of these, the first one, the easiest one, is simply called market valuation. Now market valuation really only works with a publicly traded firm or security. So basically, what you do is you get online, or you look at the stock market, you look at what that company is trading at. So, how much per share. And you look at the number of outstanding shares. You then multiply the market value of the share times the number of outstanding shares and there you go, you’ve got the value of the firm. Now that value we refer to as market capitalization or market cap. So just a quick and easy example. Let’s look at the famous clothing retailer the Gap Inc. Let’s assume that the GAP has 1,106,000 shares outstanding at a current market value of $43.10 a share. Well, the market cap of GAP Inc., is 1,106,000 times $43.10 or $47,668,600, that’s the value. So that’s the market valuation technique, finding market cap. Now this one is the quickest, it’s the easiest. But as we’ve learned earlier, is when we become extremely efficient, we often sacrifice accuracy. Oh, wait a minute. What’s not accurate about this? The market says that this is what gap is worth. And my father told me that something is worth what people are willing to pay. Clearly at the moment people are willing to pay $43.10 for every share of Gap. So isn’t that what Gap is worth? Well yeah, in the purest sense that’s what the market is willing to pay for it. But, there’s other evaluation techniques, more involved, they take more time but they can actually give us a different value. And that other value might be more significant than the market value. Why is this? Well, who’s the market driven by? The market is driven by traders, and the public, people who jump on and say hey, I’ll buy a few shares of Gap, I’ll sell a few shares of Gap. And what is the market driven by? Funny enough, that market is largely driven by ignorance. It’s also driven by just kind of following the crowd. One of the greatest traders of our times Warren Buffett says, he makes his money by selling when everyone’s buying, buying when everyone’s selling. That’s a bit simplistic but if you watch his actions that’s true. So what is Warren Buffett saying? Warren Buffett is saying the market doesn’t know. The market just follow each other. They follow common speculation. They follow market leaders. So the market as they follow whatever opinion leader they choose to follow, or follow whatever trend appears to be going on. If they maybe diverge from what could be a better estimation of value for a firm or for a security, well, then we probably wanna be able to see that and see how we think that this firm should be valued. And this probably is not going to be the market capitalization, although we will very well use market capitalization as a basis. And so that will be factored in to our decision-making process. So that’s market capitalization. We can do it quickly, we can do it easily and it’s very useful because if we do market cap and we can do it in a matter of seconds, we can then use another valuation technique and see, based on the other valuation technique, if market cap is over valuing or under valuing the firm. So, in the next section, we’re gonna look at the next type of valuation, which is called the multiples method of valuation. I’ll see you then.