Valuation

What Is Valuation?

Valuation is the insightful process of determining the current (or projected) worth of an asset or a company. There are numerous techniques used for doing a valuation. An analyst placing a value on a company takes a gander at the business' 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, albeit several other methods might be employed, for example, the capital asset pricing model (CAPM) or the dividend discount model (DDM).

What Does Valuation Tell You?

A valuation can be useful when attempting to determine the fair value of a security, which is determined by the thing a buyer will pay a seller, expecting the two players enter the transaction energetically. 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 is where valuation comes into play. Analysts do a valuation to determine whether a company or asset is overvalued or undervalued by the market.

The Two Main Categories of Valuation Methods

Absolute valuation models attempt to view as the intrinsic or "true" value of an investment based exclusively on fundamentals. Viewing at fundamentals simply means you would just zero in on such things as dividends, cash flow, and the growth rate for a single company, and not worry about some other companies. Valuation models that fall into this category include the dividend discount model, discounted cash flow model, residual income model, and asset-based model.

Relative valuation models, conversely, operate by comparing the company in question to other comparative companies. These methods involve working out multiples and ratios, for example, the price-to-earnings multiple, and comparing them to the multiples of comparative companies.

For example, if the P/E of a company is lower than the P/E multiple of a comparable company, the first company may be considered undervalued. Typically, the relative valuation model is significantly easier and quicker to calculate than the absolute valuation model, which is the reason numerous investors and analysts begin their analysis with this model.

What Earnings Mean for 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 additionally use the price-to-earnings (P/E) ratio for stock valuation, which is calculated as 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, utilizing ratios like the P/E to value a company is called a multiples-based, or multiples approach, valuation. Other multiples, like EV/EBITDA, are compared with comparative companies and historical multiples to calculate intrinsic value.

Valuation Methods

There are different ways of doing a valuation. The discounted cash flow analysis mentioned above is one method, which calculates the value of a business or asset based on its earnings potential. Other methods include taking a gander at past and comparative transactions of company or asset purchases, or comparing a company with comparable businesses and their valuations.

The comparable company analysis is a method that glances at comparable companies, in size and industry, and how they trade to determine a fair value for a company or asset. The past transaction method takes a gander at past transactions of comparable companies to determine an appropriate value. There's additionally the asset-based valuation method, which includes all the company's asset values, accepting they were sold at fair market value, to get the intrinsic value.

Sometimes doing these and afterward 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 esteeming a counseling company that has few assets; instead, an earnings-based approach like the DCF would be more appropriate.

Discounted Cash Flow Valuation

Analysts likewise place a value on an 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 a base rate of return assumed by the investor.

In the event that a company is buying a piece of machinery, the firm analyzes the cash outflow for the purchase and the extra cash inflows generated by the new asset. Every one of the cash flows are discounted to a present value, and the business determines the net present value (NPV). On the off chance that the NPV is a positive number, the company ought to make the investment and buy the asset.

Limitations of Valuation

When deciding which valuation method to use to value a stock interestingly, it's easy to become overwhelmed by the number of valuation techniques available to investors. There are valuation methods that are fairly clear while others are more involved and complicated.

Unfortunately, there's nobody method that is best suited for every situation. Each stock is different, and each industry or sector has unique characteristics that might require multiple valuation methods. At the same time, different valuation methods will produce different values for the same underlying asset or company which might lead analysts to employ the technique that provides the most favorable output.

Those interested in learning more about valuation and other financial topics might need to consider enrolling in one of the best personal finance classes.

Features

• In general, a company can be valued on its own on an absolute basis, or probably on a relative basis compared to other comparative companies or assets.
• There are several methods and techniques for showing up at a valuation — each of which might produce a different value.
• Valuations can be immediately impacted by corporate earnings or economic events that force analysts to retool their valuation models.
• Valuation is a quantitative process of determining the fair value of an asset or a firm.