Using Net Operating Income for Company Valuation

Net operating income is often used to measure a company's monetary worth. It is important to know what net operating income is before understanding how it is used for company valuation.

What Is Net Operating Income?

Net operating income is the income from operations before interest and taxes. In other words, it is the income from the ongoing operations the company undergoes. It could be income generated from investments in research and development. It could also be income generated from invested capital expenditures; such as, computer technology, company machinery, etc.

How Is Net Operating Income Used for Company Valuation?

Net operating income would go on the numerator of the equation for company valuation. Normally, the numerator uses the free cash flow that the company generates in a year and in future years. The reason that the equation goes into future years is to estimate a forward projection of the company's value taking into account all the growth prospects.

Since the forward projections of the company's net operating income is in the future, the equation must be discounted. This discounting method leaves the denominator as a factor equal to the weighted average cost of capital. This cost of capital is essentially a time value of money factor. When the cost of capital is greater and greater, the company will be devalued faster and faster. The opposite is of course true for when the cost of capital is less and less. It is computed simply as the cost of the company's financial borrowings.

If, for instance, the next five years have been projected for net operating income, then the next five years must be discounted to the present year. Taking into account the estimated weighted average cost of capital, each projected year is discounted to the present year to be then divided as a per share value. In other words, the company's valuation is estimated into a share price.

When the price per share is greater than the company's estimated value, or intrinsic value, the stock is said to be overvalued. When the price per share is under the company's intrinsic value computed using the discounted cash flows from net operating income, the stock is said to be undervalued.

Why is it Used

Now that we know how to evaluate a company's value by way of the discounted cash flows, we can move further. Understanding that the company's valuation can vary greatly from the actual market price gives us a clear view of how to make a decision based on this valuation equation. When the company is overvalued and the analysis has been done well, the decision for investment managers would be to sell the stock. In the case of an analyst, the decision would be to simply deem the company overvalued. When the company is undervalued, the decision for the investment managers would be to buy the stock, as it is a bargain compared to its intrinsic worth. In this case an analyst would simply deem the company undervalued.


blog comments powered by Disqus