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 performing 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 the market 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).
Key Takeaways
- Valuation is a quantitative process of determining the fair value of an asset, investment, or firm.
- Absolute vs. Relative Valuation: In general, a company can be valued on its own on an absolute basis, or on a relative basis compared to other similar companies or assets.
- Multiple Techniques: There are several methods and techniques for arriving at a valuation—each of which may produce different values.
- Dynamic Values: Valuations can be quickly impacted by corporate earnings or economic events that force analysts to retool their valuation models.
- Subjectivity: While quantitative in nature, valuation often involves some degree of subjective input or assumptions.
Understanding Valuation
A valuation can be useful when trying to determine the fair 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 Valuation Models
Absolute valuation models attempt to find the intrinsic or “true” value of an investment based only on fundamentals. These models focus on dividends, cash flows, and the growth rate for a single company. Models in this category include the dividend discount model, discounted cash flow model, residual income model, and asset-based model.
Relative Valuation Models
Relative valuation models, in contrast, operate by comparing the company in question to other similar companies. These methods involve calculating multiples and ratios, such as the price-to-earnings multiple, and comparing them to the multiples of similar companies.
Example: If the P/E of a company is lower than the P/E multiple of a comparable company, the original company might be considered undervalued.
Types of Valuation Methods
Comparables Method
The comparables method looks at similar companies, in size and industry, to determine a fair value for a company or asset. The past transaction method looks at past transactions of similar companies to determine an appropriate value. The asset-based valuation method adds up all the company’s asset values, assuming they were sold at fair market value, to get the intrinsic value.
In investments, a comparables approach is often synonymous with relative valuation.
Discounted Cash Flow Method (DCF)
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.
Precedent Transactions Method
The precedent transaction method compares the company being valued to other similar companies that have recently been sold. This comparison works best if the companies are in the same industry and 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.
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.
Limitations of Valuation
When deciding which valuation method to use to value a stock for the first time, it’s easy to become overwhelmed. Each industry or sector has unique characteristics that may require multiple valuation methods. 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.
Example of Valuation
A common example of valuation is a company’s market capitalization. This takes the share price of a company and multiplies it by the total shares outstanding.
Example: If a company’s share price is $10, and the company has 2 million shares outstanding, its market capitalization would be $20 million.
How Do You Calculate Valuation?
There are many ways to calculate valuation and they will differ depending on what is being valued and when. A common calculation in valuing a business involves determining the fair value of all its assets minus all its liabilities. This is an asset-based calculation.
The Purpose of Valuation
The purpose of valuation is to determine the worth of an asset or company and compare that to the current market price. This is done for a variety of reasons, such as bringing on investors, selling the company, purchasing the company, selling off assets or portions of the business, the exit of a partner, or inheritance purposes.
The Bottom Line
Valuation is the process of determining the worth of an asset or company. It provides prospective buyers with an idea of how much they should pay and sellers with an idea of how much to sell for. Valuation plays an important role in the M&A industry and is crucial for the growth of a company. Each valuation method comes with its own set of pros and cons.
Related Terms: market value, enterprise value, fair value, intrinsic value, EPS, P/E ratio.
