WHAT'S Valuation?

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?
Valuation is the analytical procedure for determining the current (or projected) worth of an asset or a company. There are plenty of techniques used for performing 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 used in valuation, although 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 an absolute basis, if not on a relative basis compared to other similar companies or assets.
There are many methods and approaches for coming to a valuation?each of which may produce a different value.
Valuations could be quickly influenced by corporate earnings or economic events that force analysts to retool their valuation models.
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, that is determined by what a buyer is ready to pay a seller, assuming both parties enter the transaction willingly. Whenever a security trades on an exchange, buyers and sellers determine the market value of a stock or bond.
The idea of intrinsic value, however, identifies the perceived value of a security based 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 an organization or asset is overvalued or undervalued by the marketplace.
Types of Valuation Models
Absolute valuation models attempt to find the intrinsic or "true" value of an investment based only on fundamentals. Looking at fundamentals simply means you would only focus on specific things like dividends, cash flow, and the growth rate for a single company, and not worry about any 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, in contrast, operate by comparing the company involved 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.
For example, if the P/E of an organization is lower than the P/E multiple of a comparable company, the initial company may 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 model.

Forms of Valuation Methods
There are various methods to do a valuation.

Comparables Method
The comparable company analysis is a method that looks at similar companies, in proportions and industry, and how they trade to determine a good value for an organization or asset. Days gone by transaction method talks about past transactions of similar companies to determine an appropriate value. There's also the asset-based valuation method, which accumulates all the company's asset values, assuming they were sold at fair market value, to have the intrinsic value.
Sometimes doing these and then weighing each is appropriate to calculate intrinsic value. Meanwhile, some methods are more appropriate for certain industries rather than others. For example, you wouldn't use an asset-based valuation method of valuing a consulting company that has few assets; instead, an earnings-based approach like the DCF would be appropriate.

Discounted Cash Flow Method
Analysts also place a value on a secured asset or investment using the cash inflows and outflows generated by the asset, called a discounted cashflow (DCF) analysis. These cash flows are discounted right into a current value utilizing a discount rate, which is an assumption about interest levels or a minimum rate of return assumed by the investor.
In case a company is buying a little bit of machinery, the firm analyzes the cash outflow for the purchase and the additional cash inflows generated by the new asset. All of the cash flows are discounted to a present-day value, and the business determines the web present value (NPV). If the NPV is a positive number, the business should make the investment and purchase the asset.

Precedent Transactions Method
The precedent transaction method compares the business being valued to other similar companies that have been recently sold. The comparison is most effective if the companies come in the same industry. The precedent transaction method is often used in mergers and acquisition transactions.

How Earnings Affect Valuation
The wages per share (EPS) formula is stated as earnings available to common shareholders divided by the amount of common stock shares outstanding. EPS can be an indicator of company profit as the more earnings an organization 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 in accordance with the earnings produced per share.

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

Limitations of Valuation
When deciding which valuation method 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. There are  click here  which are fairly straightforward while others are 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 that may require multiple valuation methods. As well, different valuation methods will produce different values for exactly the same underlying asset or company which might lead analysts to employ the technique that delivers probably the most favorable output.