What Is Valuation? How It Works and Methods Used

What Is Valuation?

Valuation is the analytical process of determining the current or projected worth of an asset or company. Many techniques are used for doing a valuation. Among other metrics, 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.

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).

Understanding Valuation

A valuation can be useful when you're trying to determine the fair value of a security determined by what a buyer is willing to pay a seller assuming that both parties enter the transaction willingly. Buyers and sellers determine the market value of a stock or bond when a security trades on an exchange.

The concept of intrinsic value refers to the perceived value of a security based on future earnings or some other company attribute. It's unrelated to the market price of a security and this is where valuation comes into play. Analysts do a valuation to determine whether a company or asset is overvalued or undervalued by the market.

Types of Valuation Models

• Absolute valuation models attempt to find the intrinsic or "true" value of an investment based only on fundamentals. You would focus only on things such as dividends, cash flow, and the growth rate for a single company. You wouldn't 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 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.

The original company might be considered undervalued if the P/E is lower than the P/E multiple of a comparable company. The relative valuation model is typically a lot easier and quicker to calculate than the absolute valuation model. This is why many investors and analysts begin their analysis with this model.

Types of Valuation Methods

You can do a valuation in various ways.

Comparables Method

The comparable company analysis looks at companies that are 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 to get the intrinsic value assuming that they were sold at fair market value.

Sometimes doing all these and then weighing each is appropriate to calculate intrinsic value but some methods are more appropriate for certain industries. You wouldn't use an asset-based valuation approach to valuing a consulting company that has few assets. 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. This is 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.

The firm analyzes the cash outflow for the purchase and the additional cash inflows generated by the new asset if a company is buying a piece of machinery. All the cash flows are discounted to a present value and the business determines the net present value (NPV). The company should invest and buy the asset if the NPV is a positive number.

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.

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 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 also use the price-to-earnings (P/E) ratio for stock valuation. This 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.

An analyst would compare the P/E ratio with other companies in the same industry and with the ratio for the broader market if the P/E ratio of a stock is 20 times earnings. Using ratios like the P/E to value a company is referred to as a multiples-based or multiples approach valuation in equity analysis. Other multiples such as EV/EBITDA are compared with similar companies and historical multiples to calculate intrinsic value.

Limitations of Valuation

It's easy to become overwhelmed by the number of valuation techniques available to investors when you're deciding which valuation method to use to value a stock for the first time. Some valuation methods are fairly straightforward. Others are more involved and complicated.

Unfortunately, no one method is best suited for every situation. Each stock is different and each industry or sector has unique characteristics that can require multiple valuation methods. Different valuation methods will produce different values for the same underlying asset or company which can lead analysts to employ the technique that provides the most favorable output.

The Bottom Line

Valuation is the process of determining the worth of an asset or company. It's important because it provides prospective buyers with an idea of how much they should pay for an asset or company and how much prospective sellers should sell for.

Valuation plays an important role in the M&A industry as well as the growth of a company. There are many valuation methods, all of which come with their pros and cons.