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 process of determining the current (or projected) worth of a secured asset or a company. There are lots of techniques used for performing a valuation. An analyst placing a value on a company looks at their 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 employed in valuation, although several other methods may be employed such as the capital asset pricing model (CAPM) or the dividend discount model (DDM).

KEY TAKEAWAYS
Valuation is really 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 techniques for arriving at a valuation?each of which may create 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 extent of subjective input or assumptions.
Understanding Valuation
A valuation can be useful when trying to determine the fair value of a security, which is determined by just what a buyer is willing 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 concept 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 execute a valuation to determine whether an organization or asset is overvalued or undervalued by the marketplace.
Types of Valuation Models
Absolute valuation models attempt to discover the intrinsic or "true" value of an investment based only on fundamentals. Considering fundamentals simply means you would only focus on specific things like dividends, cashflow, and the growth rate for an individual company, and not be worried about any companies. Valuation models that fall into this category include the dividend discount model, discounted cashflow model, residual income model, and asset-based model.
Relative valuation models, on the other hand, operate by comparing the business 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 instance, if the P/E of an organization is lower compared to the P/E multiple of a comparable company, the original company might be considered undervalued. Typically, the relative valuation model is a lot easier and quicker to calculate compared to the absolute valuation model, which is why many investors and analysts begin their analysis with this particular model.

Types of Valuation Methods
There are various ways 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 fair value for an organization or asset. Days gone by transaction method looks at past transactions of similar companies to determine an appropriate value. Additionally, there is 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 all of these and weighing each is suitable to calculate intrinsic value. Meanwhile, some methods tend to be more befitting 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 just like the DCF would be more appropriate.

Discounted CASHFLOW 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 into a current value using a discount rate, which is an assumption about interest levels or perhaps a minimum rate of return assumed by the investor.
If a company is investing in a piece of machinery, the firm analyzes the money outflow for the purchase and the additional cash inflows generated by the new asset.  Valuation Surveyor Thames Ditton  of the cash flows are discounted to a present-day value, and the business determines the web present value (NPV). If the NPV is really a positive number, the business should make the investment and buy the asset.

Precedent Transactions Method
The precedent transaction method compares the company being valued to other similar companies which have been recently sold. The comparison works best if the companies come in exactly the same industry. The precedent transaction method is frequently employed in mergers and acquisition transactions.

How Earnings Affect Valuation
The wages per share (EPS) formula is stated as earnings open to common shareholders divided by the number 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 is 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 wages 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 other companies in the same industry and with the ratio for the broader market. In equity analysis, using ratios just like the P/E to value a company is named a multiples-based, or multiples approach, valuation. Other multiples, such as EV/EBITDA, are weighed against 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, you can become overwhelmed by the number of valuation techniques available to investors. There are valuation methods which are fairly straightforward while some tend to be more involved and complicated.

Unfortunately, there's no one method that's best suited for each situation. Each stock differs, and each industry or sector has unique characteristics that may require multiple valuation methods. Concurrently, different valuation methods will produce different values for the same underlying asset or company which might lead analysts to hire the technique that provides the most favorable output.