How does the Basic Valuation Model work ?

Basic Valuation Model:

If you want to value assets or security , you have to present the value of all future cash flows which are linked with those assets over the specified time period. Do you know, We are day in day out using various valuation models . You will under Basic Valuation model through this post.

Say, you have seen ad on 99 acres and You want to invest in a house or office and want to give on rent . We easily calculate rent yield and decide whether to buy or not . e.g. you are buying an office in one of the well known areas in your city with an objective of giving on rent . Say property is costing Rs.30 Lakhs and you will get Annual rental of Rs.1,80,000 . Now based on the type of assets , you have decided that you want at least 6% return on investment for real estate property and you are planning to hold it for 5 years . Say at the end of 5 years you can sell this office @ Rs.40 Lakhs . Now with this small example , let us develop a valuation model .

Click here to download excel sheet with Valuation model

Valuation Model using Discounted Cash Flow Method:

Now see above example , you are getting rental of Rs.1.8 Lakh in advance but not in one year . You will receive year on year so for better comparison we have to discount it with our expected rate of return. What is the expected rate of return ? This depends on the class of assets and company policy . In case of individual , risk profile of investor .For simplicity , as per your company policy , you expect your real estate property i.e. office to earn you at least 6% p.a. So we have discounted all cashflow with a 6% discounted factor . We call it Time Value of Money . You can derive discount value using excel formula below :

Discount value = ( 1/(1+R)^T) here in excel we have mentioned as =1/(1+6%)^H2 . R means required rate of return and T means year of discounting. In our case it will start from year 1 to year 5 . We multiply total cash flow of each year with discounted value to derive discounted cash flow and total all cash flow to derive Net Present value .

Net Present Value :

We have arrived at Net present value of Rs.8,72,211 i.e. total purchase value of office, yearly rental and sale value of office at the end of 5 years with discounting @ 6% . It is positive , it means asset is giving a return more than my expected rate of rate .

Actual Rate of Return (IRR) :

Now if I have to compare what is the actual return asset is giving , you can use excel formula of IRR by selecting the cash flow of each year . Answer is 6.20% in the given case which is a more than expected return of 6% .

Since this is a basic valuation model, depreciation and Income tax are ignored. We will cover these in another post.

Valuation of other Assets :

Same Valuation principles will apply for other classes of assets with only change in calculating cash flow. If you are investing in any Plant and Machinery and it will cost you say Rs.30 crore , you can consider a similar model . One has to reduce deprecation from the margin on sale of product to arrive at taxable income and to apply tax on it . Depreciation is non-cash expenditure so need to add back. We will cover a detailed financial model in our next post.

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