What Is Valuation? (2024)

What Is Valuation?

Valuation is the analytical process of determining the current (or projected) worth of an asset or a company.There are many techniques used for doing a valuation. An analyst placing a value on a company looks at the business's management, the composition of its capital structure, the prospect of future earnings, and themarket value of its assets, among other metrics.

Fundamental analysis is often employed in valuation, although several other methods may be employed such as the capital asset pricing model (CAPM) or the dividend discount model (DDM).

Understanding Valuation

A valuation can be useful when trying todetermine thefair value of a security, which is determined by what a buyer is willing to pay a seller, assuming both parties enter the transaction willingly. When a security trades on an exchange, buyers and sellers determine the market value of a stock or bond.

The concept of intrinsic value, however, refers to the perceived value of a security based on future earnings or some other company attribute unrelated to the market price of a security. That's where valuation comes into play. Analysts do a valuation to determine whether a company or asset is overvalued or undervalued by the market.

Types of Valuation Models

• Absolute valuationmodelsattempt to find the intrinsic or "true" value of an investment based only on fundamentals. Looking at fundamentals simply means you would only focus on such things as dividends, cash flow, and the growth rate for a single company, and not worry about any other companies. Valuation models that fall into this category include the dividend discount model, discounted cash flow model,residual incomemodel, and asset-based model.
• Relative valuationmodels,in contrast, operate by comparing the company in question to other similar companies. These methods involve calculating multiples andratios, such as the price-to-earnings multiple, and comparing them to the multiples of similar companies.

For example, if the P/E of acompanyis lower than the P/E multiple of a comparable company, theoriginal company might be consideredundervalued. Typically, the relative valuation modelis a lot easier and quicker to calculatethan the absolutevaluationmodel, which is why many investors and analysts begintheir analysis with this model.

Types of Valuation Methods

There are various ways to do a valuation.

Comparables Method

The comparable company analysisis a method thatlooks at similar companies, in size and industry,and how they trade to determine a fair value for a companyor asset. The past transaction method looks at past transactions of similar companies to determine an appropriate value. There's also the asset-based valuation method, which adds up all the company's asset values, assuming they were sold at fair market value, to get the intrinsic value.

Sometimes doing all of these and then weighing each is appropriate to calculate intrinsic value. Meanwhile, some methods are more appropriate for certain industries and not others. For example, you wouldn't use an asset-based valuation approach to valuing a consulting company that has few assets; instead, an earnings-based approach like the DCF would be more appropriate.

Discounted Cash Flow Method

Analysts also place a value on an asset or investment using the cash inflows and outflows generated by the asset, called a discounted cash flow(DCF) analysis. These cash flows are discounted into a current value using a discount rate, which is an assumption about interest rates or a minimum rate of return assumed by the investor.

If a company is buying a piece of machinery, the firm analyzes the cash outflow for the purchase and the additional cash inflows generated by the new asset. All the cash flows are discounted to a present value, and the business determines the net present value (NPV). If the NPV is a positive number, the company should make the investment and buy the asset.

Precedent Transactions Method

The precedent transaction method compares the company being valued to other similar companies that have recently been sold. The comparison works best if the companies are in the same industry. The precedent transaction method is often employed in mergers and acquisition transactions.

How Earnings Affect Valuation

The earnings per share(EPS)formula is stated as earnings available to common shareholders divided by the number of common stock shares outstanding. EPS is an indicator of company profit because the more earnings a company can generate per share, the more valuable each share is to investors.

Analysts also use the price-to-earnings (P/E) ratio for stock valuation, which is calculated as the market price per share divided by EPS. The P/E ratio calculates how expensive a stock price is relative to the earnings produced per share.

For example, if the P/E ratio of a stock is 20 times earnings, an analyst compares that P/E ratio with other companies in the same industry and with the ratio for the broader market. In equity analysis, using ratios like the P/E to value a company is called a multiples-based, or multiples approach,valuation. Other multiples, such as EV/EBITDA, are compared with similar companies and historical multiples to calculate intrinsicvalue.

Limitations of Valuation

When deciding whichvaluationmethod to use to value a stock for the first time, it's easy to become overwhelmedby the number of valuation techniques available to investors. There are valuation methods that are fairly straightforward whileothers are more involved and complicated.

Unfortunately, there'sno one method that'sbest suited for every situation. Each stock is different, and each industry or sector has unique characteristics that may require multiplevaluation methods. At the same time, different valuation methods will produce different values for the same underlying asset or company which may lead analysts to employ the technique that provides the most favorable output.

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The Bottom Line

Valuation is the process of determining the worth of an asset or company. Valuation is important because it provides prospective buyers with an idea of how much they should pay for an asset or company and for prospective sellers, how much they should sell for.

Valuation plays an important role in the M&A industry, as well as in regard to the growth of a company. There are many valuation methods, all of which come with their pros and cons.