Recently, the A-share market has reached unprecedented levels of activity, showcasing an extraordinary surge in both prices and trading volumesAmid this frenzy, stock indices are soaring, and newly listed companies are showcasing astonishing gains, with some experiencing increases of over 1700%. This whimsical atmosphere creates the illusion of a financial utopia, leading investors to feel as though they are part of a dream-like scenario where wealth is rapidly expandingHowever, beneath this wild surface lies a fundamental question that requires serious consideration: what is the true value of a company, and how should one determine its fair price?

In the context of the volatile A-share market, the valuation of companies has emerged as a critical topic that necessitates in-depth discussion.

Some might believe that valuation is a concern restricted to financial elites, far removed from the day-to-day lives of ordinary individuals earning modest salaries

In reality, however, each of us engages in a subconscious process of valuation during our routine investment activities.

When we monitor a company's stock over time and witness its price skyrocketing, we may feel an innate sense that the share price is inflated and destined to plummetThis subconscious judgment essentially encapsulates a simplified valuation process, even if we are unaware of it.

Professional investment institutions utilize a more complex and systematic approach to valuationAmong the various methods, one straightforward approach is the confidence valuation method, which was quite prevalent in the Chinese market a decade agoRather than merely assessing the intrinsic value of the company, investor optimism regarding the overall environment played a predominant role.

For instance, in 2013, Xu Xiaoping of Zhenge Fund and Shen Nanpeng of Sequoia Capital engaged in fierce debates over the valuation of an AI company, Grinshen Tong

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The discussion centered on whether the company was worth $500 billion or $100 billion – a valuation argument that even surpassed the current market cap of OpenAI.

At that time, the soaring economic climate and explosive technological advancements ignited the imaginations of investors, leading to distinct characteristics in company valuations during this periodFirstly, the valuation numbers were often set rather arbitrarily, with founders' proposed valuations frequently being acceptedSecondly, the valuations demonstrated considerable volatility, periodically being overestimated or underestimated, lacking stability and precision.

To illustrate this framework, consider a private kitchen opening in the culinary marketIf it had established itself a decade earlier as a pioneer in Chinese cuisine and sought funding, an investor's willingness to invest $1 million for a 10% stake would yield an implied valuation of $10 million

If another investor were to offer $2 million for the same stake, the valuation would balloon to $20 millionThis seemingly absurd valuation process reflects an important truth about company valuations under the confidence method: the value largely depends upon the investors’ confidence and imaginative potential.

Real-life instances provoke further reflectionWhen Apple was founded in 1976, Steve Jobs, Steve Wozniak, and Ronald Wayne collectively held a 100% stake, having raised just $1,250.

However, just 12 days after its incorporation, Wayne sold his entire 10% share for a mere $800 due to skepticism about the company’s prospects when Apple’s valuation was only $8,000.

To everyone’s surprise, just six months later, Mike Markkula invested $250,000 to acquire 26% of Apple, causing its valuation to skyrocket to $1 million.

During this period, Apple hadn’t achieved any groundbreaking commercial milestones or generated massive profits; the valuation shift mainly stemmed from differing levels of confidence among investors regarding Apple’s future potential

While a high level of confidence can yield substantial financial returns for investors, it can also conceal imminent risks.

For many companies, the multitude of retail investors in the stock market serves as a reality check for determining true valueTheir investment decisions and market reactions have become crucial references for many institutions in assessing valuationsThis has given rise to a second valuation method—the market method, also known as relative valuation or comparable company analysis.

The market method's core lies in identifying comparable publicly traded companies as benchmarks, allowing analysts to assess the target company's value based on these references' financial health, market prospects, and other factorsTypically, if the sector is relatively novel and lacks adequate comparables, the confidence valuation method may prevail

In contrast, when the market becomes more mature and comparable companies abound, the market approach becomes the preferred valuation methodFrom a company’s lifecycle perspective, pre-IPO and post-IPO phases serve as two crucial milestones.

Start-ups primarily undergo several rounds of financing in the primary market, with individuals typically being affluent investors or venture capital fundsThese investments are often substantial, and ordinary investors find it difficult to participateAfter reaching a certain scale, these companies enter the secondary market for public share issuance, providing average investors with opportunities to partake.

Historically, the primary market has often led the development of the secondary market, allowing investors to profit from time differences in a company's growth trajectoryAfter all, venture capital’s essence is to seek significant returns amid risk.

Nevertheless, this investment model is fraught with uncertainties

For instance, during times of ample market liquidity, investors often rush to seize investment opportunities while neglecting thorough analysis of the company’s fundamentals, believing that a broad array of investments will inevitably yield one or more winnersConversely, when capital becomes scarce, the dynamics reverse, with the secondary market’s performance influencing the primary marketIn such scenarios, investors become more rational, emphasizing actual data and performance in valuations, thus urging a return to rational evaluations.

In the application of the market method, ratios such as price-to-earnings (P/E), price-to-book (P/B), price-to-sales (P/S), and price-to-cash flow (P/CF) are common valuation toolsAmong these, the P/E ratio is the most frequently utilized, reflecting the market's expectations for a company’s earnings.

The formula for calculation is as follows: P1 = Stock Price per Share / Earnings per Share or Market Capitalization / Total Earnings

Rearranging gives us Valuation = P Ratio x EarningsHowever, accurately predicting future profits is crucial to applying the P/E method effectively.

Generally, in a relatively stable environment, a company's future expected profits correlate strongly with its current income performanceIn emerging sectors, analysts often refer to the average net profit over the past two to three years; for cyclical industries such as banking or real estate, analysis might span eight to ten years of historical averages.

Of course, if the company is not profitable and has negative earnings, the P/E ratio becomes inapplicable and other metrics such as the P/S ratio or P/B ratio should be considered for valuation instead.

Selecting comparable companies is critical when determining the P/E ratio, as it directly influences the valuation multiples

In the competitive business landscape, companies strive to become industry leaders, affecting not only their brand image and market share but also enabling them to secure higher valuation levels.

For example, in 2018, Haidilao gained momentum as it went public in Hong Kong, achieving the status of the first stock in the hotpot industry with an issuance P/E ratio exceeding 50 timesAfter its IPO, the stock price continued to rise, boosting valuations across the entire hotpot sector, as well as the broader dining industryConversely, Nayuki Tea, although managing to transition from an initial valuation of HKD 12.46 billion to HKD 34 billion within six months due to its first-mover advantage compared to competitors like Heytea and Miss Ice City, faced a significant plunge in stock price and lost nearly HKD 5 billion in market capitalizationThe scenario unfolded as investors perceived Nayuki Tea as emblematic of a new tea culture appealing to China's youth, leading to an initially high P/E ratio at valuation.

However, as market sentiments shifted, retail investors ultimately opted to express their sentiments through selling, resulting in a sharp decline in share price.

This underscores the point that while the market method appears to be grounded in data and formulas, reality reveals that market sentiments remain an influential and often unpredictable factor

These include individual investor emotions and the prevailing atmosphere and expectations of the entire market.

Warren Buffett, the "Oracle of Omaha," emphasizes the importance of company valuations in his writings about value investingHowever, he seldom engages with high-valuation companiesThis seemingly contradictory behavior reflects the complexities and uncertainties surrounding emotional factors within high-valuation companiesEven investment legends like Buffett find it challenging to gauge the impact of emotional components on a company’s valuation accurately.

In summary, we have delved into the methods used for valuation in the primary market and the contributing factors impacting market capitalization in the secondary market.

Nevertheless, in the real world of stock trading, most investors often do not genuinely concern themselves with whether a company's valuation is reasonable; market sentiments, in most cases, become the primary forces driving stock price trends.

Through one market surge after another, we endure the tribulations of the financial world while gradually achieving a base level of financial education