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 doing a 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).
- Valuation is a quantitative process of determining the fair value of an asset, investment, or firm.
- In general, a company can be valued on its own on an absolute basis, or else on a relative basis
compared to other similar companies or assets. - There are several methods and techniques for arriving at a valuation—each of which may produce 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 degree of subjective input or
assumptions.
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 such things as
dividends, cash flow, and the growth rate for a single company, and not worry about any 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, 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.
Types of Valuation Methods:
- 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. The past transaction method looks at
past transactions of similar companies to determine an appropriate value. There’s also the asset-based
valuation method, which adds up all the company’s asset values, assuming they were sold at fair market
value, to get the intrinsic value.
Sometimes doing all of these and then 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 valuing a consulting company that has few assets;
instead, an earnings-based approach like the DCF would be more appropriate. - Discounted Cash Flow Method:
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.
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 new asset. All the cash flows are discounted to a present value,
and the business determines the net present value (NPV). If the NPV is a positive number, the company
should make the investment and buy the asset. - Precedent Transactions Method:
The precedent transaction method compares the company being valued to other similar companies that
have recently been sold. The comparison works best if the companies are in the same industry. The
precedent transaction method is often employed in mergers and acquisition transactions.