What is “valuation” – and why does it matter to investors?

You’ll often hear me say a stock is overvalued or undervalued in Red Hot Penny Shares. Or I might say something like: “The valuation of this stock is R10 – but it’s trading at R5.” So, what exactly is valuation? How is it calculated? And most importantly… what should you actually do with that figure?

Valuation defined – or is it?

Investopedia defines valuation as: “A quantitative process of determining the fair value of an asset, investment or firm.”

That’s the textbook version. And yes, it’s accurate – but it can also feel a bit abstract. So, let’s get a little more practical.

Let’s start with a can of Coke.

How much is a can of Coca-Cola worth? R5? R10? R50? Or… zero?

The answer: it depends.

Imagine you have one can of Coke…

• You’re in the middle of a desert.
• There are 50 thirsty people.
• That single can suddenly becomes very valuable.

Now imagine the opposite:

• You’re sitting on a warehouse full of Coke.
• And sugary drinks just got banned by law.
• The value of that Coke? Maybe zero (at least in a formal market).

This is the first truth about valuation: Value is often in the eye of the beholder.

That’s also why stock prices move around every day – different investors value the same company differently based on what they believe will happen in the future.

So how does this help you as an investor?

As a value investor, I’m looking for companies where the intrinsic value – the real worth of the business – is higher than the market price. That gap creates a margin of safety.

If I can buy at R5 when I think the company is worth R10, it gives me: Downside protection – less risk if things go wrong, and upside potential – more reward if others realise the value I already see.

How do we calculate this so-called “value”?

There’s no single answer. But here are the most common ways investors estimate valuation.

Valuation Method #1: Precedent Transactions

This is about looking at deals that have already happened.

Say a big telecoms company buys a smaller one. That price gives us a clue: “This is what the market was willing to pay for a similar business.”

For example, in mining, we might compare the price investors pay per ounce of gold reserves across various international gold companies. That becomes a benchmark for valuing another gold miner with similar reserves.

Valuation Method #2: Ratio Analysis & Comparable Companies

Here, we compare key financial ratios of a company to its peers.

The P/E ratio (Price-to-Earnings) is the most common. It tells you how much you’re paying for every R1 of earnings.
Other ratios include:

• Dividend yield (income investors love this)
• Debt-to-equity (how much leverage a company uses)
• Price-to-sales or Price-to-book ratios

It’s a quick way to spot whether a company is cheap or expensive relative to others.

Valuation Method #3: Discounted Cash Flow (DCF)

This one’s more detailed – and technical.

It’s based on the idea that a company’s value is equal to all the future cash flows it will generate… brought back to today’s value (discounted to present value).

This works best for companies with stable, predictable cash flows – like a mine with a set life-of-mine plan and clear production targets.
But one wrong assumption – growth rate, commodity price, interest rate – can skew the whole model.

Valuation Method #4: Asset-Based Valuation

Some companies are worth more dead than alive – especially after a turnaround or in slow-growth sectors.

This method looks at the value of the company’s assets minus its liabilities – known as Net Asset Value (NAV) or book value.

Divide this by the number of shares, and you get a per-share value to compare to the current market price.

Valuation Method #5: Sum of the Parts (SOTP)

This is useful when valuing investment holding companies. These companies often own multiple businesses – some fully owned, others just minority stakes.

To value them, we tally up the value of all their investments. Values for these investments or companies could be drawn from financials statements, estimates, director valuations or directly by getting their market values from the stock market in the case of listed investments. This gives us a per share value like “Valuation method #4”.

Simply put – valuation isn’t about finding a perfect number. It’s about stacking the odds in your favour.

It won’t guarantee profits. But it helps you avoid overpaying – and gives you a logical framework to decide if a stock is worth it.

Valuation is both an art and a science. You can make it as simple or complex as you like. What matters most is that it gives you conviction when the market is noisy.