What Is Valuation?
Let me explain valuation to you directly: it's the process where I, as an analyst, would use a company's latest financial statements to figure out its current or projected value. We employ many techniques for this. When valuing a company, I look at factors like the business's management, its capital structure composition, future earnings prospects, and the market value of its assets.
We often use fundamental analysis in valuation, but other methods like the capital asset pricing model (CAPM) or the dividend discount model (DDM) can also come into play.
Key Takeaways
Valuation is a quantitative process to determine the fair value of an asset, investment, or firm. You can value a company on an absolute basis or relatively compared to similar ones. Several methods and techniques exist, each potentially yielding different values. Corporate earnings or economic events can quickly affect valuations, prompting analysts to adjust models. While quantitative, valuation often includes subjective inputs or assumptions.
Understanding Valuation
A valuation helps when you're determining the fair value of a security, based on what a buyer would pay a seller if both agree willingly. On exchanges, buyers and sellers set the market value of stocks or bonds through trading.
Intrinsic value is the perceived value of a security from future earnings or other attributes, separate from market price. This is where valuation fits in—I do it to check if a company or asset is overvalued or undervalued by the market.
Types of Valuation Models
Absolute valuation models aim to find the intrinsic or true value of an investment solely from fundamentals. You'd focus on dividends, cash flow, and growth rate for one company, ignoring others. Models in this category include the dividend discount model, discounted cash flow model, residual income model, and asset-based model.
Relative valuation models compare the company to similar ones by calculating multiples and ratios like price-to-earnings, then comparing them. If the P/E is lower than a comparable company's, the original might be undervalued. This model is easier and quicker, so many start here.
Types of Valuation Methods
You can perform valuation in various ways. The comparables method examines similar companies in size and industry to determine fair value, or looks at past transactions. The asset-based method sums up all asset values at fair market value minus liabilities.
Sometimes you weigh multiple methods to calculate intrinsic value, but certain ones suit specific industries better. For a consulting firm with few assets, avoid asset-based; use earnings-based like DCF instead.
In discounted cash flow (DCF) analysis, we value assets using generated cash inflows and outflows, discounted to present value with a rate assuming interest or minimum return. For machinery purchases, analyze outflows and inflows to find net present value (NPV)—invest if positive.
The precedent transaction method compares to recently sold similar companies, best in the same industry, often used in mergers and acquisitions.
How Earnings Affect Valuation
Earnings per share (EPS) is earnings available to common shareholders divided by outstanding shares—it's a profit indicator, making shares more valuable with higher EPS.
The price-to-earnings (P/E) ratio is market price per share divided by EPS, showing how expensive the stock is relative to earnings. Compare it to industry peers or the market. This multiples approach, including EV/EBITDA, helps calculate intrinsic value against similars and history.
Limitations of Valuation
With so many techniques, it's easy to get overwhelmed choosing one for a stock. Some are straightforward, others complex. No method fits every situation—stocks differ, and industries have unique traits requiring multiple methods. Different methods can yield varying values for the same asset, leading analysts to pick favorable ones.
What Is an Example of Valuation?
A common example is market capitalization: multiply share price by total shares outstanding. If shares are $10 with two million outstanding, it's $20 million.
How Do You Calculate Valuation?
Calculations vary by what's valued and when. A basic business valuation subtracts all liabilities from the fair value of all assets—an asset-based approach.
What Is the Purpose of Valuation?
Valuation determines an asset or company's worth compared to market price, for reasons like attracting investors, selling or buying the company, divesting assets, partner exits, or inheritance.
The Bottom Line
Valuation determines an asset or company's worth, guiding buyers on payment and sellers on price. It's key in M&A and company growth, with methods having pros and cons.
