CORPORATE FINANCE FINANCIAL ANALYSIS
What Is Valuation?
By JAMES CHEN
Updated September 13, 2022
Reviewed by JULIUS MANSA
Fact checked by PATRICE WILLIAMS
Valuation
Investopedia / Mira Norian
What Is Valuation?
https://postheaven.net/construction323/residential-valuation-surveyor-jobs is the analytical procedure for 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 an organization looks at the business's management, the composition of its capital structure, the chance of future earnings, and the marketplace value of its assets, among other metrics.
Fundamental analysis is often employed in valuation, although several other methods could be employed like 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.
In general, a company can be valued alone on a complete basis, if not on a relative basis in comparison to other similar companies or assets.
There are lots of methods and approaches for coming to a valuation?all of which may create a different value.
Valuations can be quickly impacted by corporate earnings or economic events that force analysts to retool their valuation models.
While quantitative in nature, valuation often involves some extent of subjective input or assumptions.
Understanding Valuation
A valuation can be useful when trying to determine the fair value of a security, that 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, identifies the perceived value of a security predicated on future earnings or various other company attribute unrelated to the market price of a security. That's where valuation comes into play. Analysts do a valuation to find out whether a company or asset is overvalued or undervalued by the marketplace.
Types of Valuation Models
Absolute valuation models try to discover the intrinsic or "true" value of an investment based only on fundamentals. Considering fundamentals simply means you'll only focus on such things as dividends, cash flow, and the growth rate for a single company, and not be worried about any other companies. Valuation models that fall into this category are the dividend discount model, discounted cash flow model, residual income model, and asset-based model.
Relative valuation models, on the other hand, operate by comparing the company involved to other similar companies. These methods involve calculating multiples and ratios, like the price-to-earnings multiple, and comparing them to the multiples of similar companies.
For instance, if the P/E of a company is lower compared to the P/E multiple of a comparable company, the original company might be considered undervalued. Typically, the relative valuation model is a lot easier and quicker to calculate than the absolute valuation model, which is why many investors and analysts begin their analysis with this particular model.
Types of Valuation Methods
There are various ways to do a valuation.
Comparables Method
The comparable company analysis is a method that looks at similar companies, in size and industry, and how they trade to determine a fair value for a company or asset. Days gone by transaction method looks at past transactions of similar companies to find out an appropriate value. Additionally, there is the asset-based valuation method, which accumulates all the company's asset values, assuming these were sold at fair market value, to get the intrinsic value.
Sometimes doing these and weighing each is suitable to calculate intrinsic value. Meanwhile, some methods tend to be more appropriate for certain industries and not others. For example, you wouldn't use an asset-based valuation approach to valuing a consulting company which has few assets; instead, an earnings-based approach just like the DCF would be more appropriate.
Discounted CASHFLOW Method
Analysts also place a value on a secured asset or investment utilizing 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 utilizing a discount rate, which is an assumption about interest rates or perhaps 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 brand new asset. All the cash flows are discounted to a present-day value, and the business enterprise determines the net present value (NPV). If the NPV is really a positive number, the business should make the investment and purchase the asset.
Precedent Transactions Method
The precedent transaction method compares the company being valued to other similar companies which have been recently sold. The comparison works best if the companies come in the same industry. The precedent transaction method is frequently 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 can be an indicator of company profit because the more earnings a company can generate per share, the more valuable each share would be to investors.
Analysts also utilize 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 just like the P/E to value an organization 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 intrinsic value.
Limitations of Valuation
When deciding which valuation solution to use to value a stock for the very first time, it's easy to become overwhelmed by the number of valuation techniques open to investors. You can find valuation methods that are fairly straightforward while others tend to be more involved and complicated.
Unfortunately, there's no one method that's best suited for each situation. Each stock is different, and each industry or sector has unique characteristics which could require multiple valuation 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 delivers the most favorable output.