REVIEWED BY JAMES CHEN Updated Apr 18, 2019
What Is 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.
Valuation Models: Apple’s Stock Analysis With CAPM
What Does Valuation Tell You?
A valuation can be useful when trying to determine the fair value of a security, which is determined by what a buyer is willing to pay a seller, assuming both parties enter the transaction willingly. 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’s 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 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.
For example, if the P/E of a company is lower than 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 than the absolute valuation model, which is why many investors and analysts begin their analysis with this model.
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, 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, using ratios like the P/E to value a company is called a multiples-based, or multiples approach, valuation. Other multiples, such as EV/EBITDA, are compared with similar companies and historical multiples to calculate intrinsic value.
There are various ways to do 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 looking at past and similar transactions of company or asset purchases, or comparing a company with similar businesses and their valuations.
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, and 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 Valuation
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.
- Valuation is the analytical process of determining the current (or projected) worth of an asset or a company.
- There are several methods and techniques for arriving at a valuation—each of which may produce a different value.
- Valuation can be affected by corporate earnings or economic events.
Limitations of Valuation
When deciding which valuation method to use to value a stock for the first time, it’s easy to become overwhelmed by the number of valuation techniques available to investors. There are valuation methods that are fairly straightforward while others are more involved and complicated.
Unfortunately, there’s no one method that’s best suited for every situation. Each stock is different, and each industry or sector has unique characteristics that may require multiple valuation methods. At the same time, different valuation methods will produce different values for the same underlying asset or company which may lead analysts to employ the technique that provides the most favorable output.
Valuation of “Intangible” Assets
What is an “Intangible” Asset?
“Intangibles” such as customer goodwill, name recognition, and customer lists are valuable non-material assets that can be appraised just like physical equipment, real estate, accounts receivable, and securities. In order for your business to be successful, you’ll want to understand the importance of intangibles. Below are some of the most important intangible assets, and some ways they are valued.
Brand Names or Trademarks: Brand names and trademarks can be extremely valuable. Some, such as “jello,” “xerox,” and “kleenex” have nearly become generic terms. A common valuation method is based on how much more a company can charge for its products than relatively unknown competitors.
Contracts: Certain contracts, such as employment, affiliation, advertising, or sales contracts, can be treated as intangible assets because they add value to a company. For example, a long-term lease at below-market rates can represent a huge overhead savings. Or, when a business is sold, the president of the selling company may contract to remain for a certain period. This contract is valuable because it saves the cost to replace the president with a new executive who would have to learn the business and take time to become as effective. Other types of valuable contracts might be subscription contracts (for example, a cable company’s revenue is based largely on subscriptions) or long-term service contracts sold by the company.
Franchises and Other Licenses: Franchises that are well-recognized and have a long track record are valuable. One common way to value franchises is based on profit advantage over similar businesses by virtue of the franchise.
Goodwill: Goodwill is based on your company’s reputation and relationships with customers, vendors and the community, and its participation in trade-related activities. In broad terms, goodwill is a measure of your company’s reputation, and of how willing these individuals would be to continue doing business with your company. Goodwill is often lumped with other intangibles in valuation because it can be difficult to separate the value of each intangible. At a base level, goodwill can be considered the value of having an established business, so that a buyer would not have to assemble the business and seek customers from the ground up.
Patents and Patent Applications: The value of a patent depends on its economic and legal lifespan. The value of a patent application depends on the strength of its claims.
Proprietary Lists: Many types of lists, such as customer or subscription lists, are often compiled for internal use, bought, or sold. Lists are especially valuable if they represent ongoing business relationships. For example, if a newspaper gets 80 percent of its advertising revenue from companies on a customer list, that list is a critical business tool. Values may be based on the cost to replace a list, or the repeat sales generated.
Secret Processes, Methods, and Formulas: Often these assets are not patented, and valuation must be made based on profit advantage or cost savings provided by the asset. Because these assets are volatile-secrets are precarious-an appraiser’s judgment often plays heavily in these valuations.
Tax Credits For Past Losses: The IRS allows certain losses to be carried back or carried forward. If a company has losses, they may be carried forward for a certain number of years to offset profits, resulting in a tax saving. The anticipated tax saving can often be estimated, providing a value for this asset.
Technical Libraries and Other Specialized Information Repositories: Many libraries contain nearly irreplaceable material, and can be extraordinarily difficult to recreate. These assets are often valued by the cost of recreating them, minus losses for obsolescence.
As a small business owner, you likely have questions about how to value intangible assets in your company. Let a legal expert skilled in business and commercial law assist you today.
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In finance, valuation is the process of determining the present value (PV) of an asset. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company). Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.
- 1Valuation overview
- 3Business valuation
- 4Specialised cases
- 5See also
Common terms for the value of an asset or liability are market value, fair value, and intrinsic value. The meanings of these terms differ. For instance, when an analyst believes a stock’s intrinsic value is greater (or less) than its market price, an analyst makes a “buy” (or “sell”) recommendation. Moreover, an asset’s intrinsic value may be subject to personal opinion and vary among analysts. The International Valuation Standards include definitions for common bases of value and generally accepted practice procedures for valuing assets of all types. Regardless, the valuation itself is done generally using one or more of the following approaches; but see also, Outline of finance #Valuation:
- Absolute value models (“Intrinsic valuation“) that determine the present value of an asset’s expected future cash flows. These models take two general forms: multi-period models such as discounted cash flow models, or single-period models such as the Gordon model (which, in fact, often “telescope” the former). These models rely on mathematics rather than price observation. See #Discounted cash flow valuation.
- Relative value models determine value based on the observation of market prices of ‘comparable’ assets, relative to a common variable like earnings, cashflows, book value or sales. This result, will often be used to complement / assess the intrinsic valuation. See #Relative valuation.
- Option pricing models, in this context, are used to value specific balance-sheet items, or the asset itself, when these have option-like characteristics. Examples of the first type are warrants, employee stock options, and investments with embedded options such as callable bonds; the second type are usually real options. The most common option pricing models employed here are the Black–Scholes–Merton models and lattice models. This approach is sometimes referred to as contingent claim valuation, in that the value will be contingent on some other asset; see #Contingent claim valuation.
In finance, valuation analysis is required for many reasons including tax assessment, wills and estates, divorce settlements, business analysis, and basic bookkeeping and accounting. Since the value of things fluctuates over time, valuations are as of a specific date like the end of the accounting quarter or year. They may alternatively be mark-to-marketestimates of the current value of assets or liabilities as of this minute or this day for the purposes of managing portfolios and associated financial risk (for example, within large financial firms including investment banks and stockbrokers).
Some balance sheet items are much easier to value than others. Publicly traded stocks and bonds have prices that are quoted frequently and readily available. Other assets are harder to value. For instance, private firms that have no frequently quoted price. Additionally, financial instruments that have prices that are partly dependent on theoretical models of one kind or another are difficult to value. For example, options are generally valued using the Black–Scholes model while the liabilities of life assurance firms are valued using the theory of present value. Intangible business assets, like goodwill and intellectual property, are open to a wide range of value interpretations.
It is possible and conventional for financial professionals to make their own estimates of the valuations of assets or liabilities that they are interested in. Their calculations are of various kinds including analyses of companies that focus on price-to-book, price-to-earnings, price-to-cash-flow and present value calculations, and analyses of bonds that focus on credit ratings, assessments of default risk, risk premia, and levels of real interest rates. All of these approaches may be thought of as creating estimates of value that compete for credibility with the prevailing share or bond prices, where applicable, and may or may not result in buying or selling by market participants. Where the valuation is for the purpose of a merger or acquisition the respective businesses make available further detailed financial information, usually on the completion of a non-disclosure agreement.
It is important to note that valuation requires judgment and assumptions:
- There are different circumstances and purposes to value an asset (e.g., distressed firm, tax purposes, mergers and acquisitions, financial reporting). Such differences can lead to different valuation methods or different interpretations of the method results
- All valuation models and methods have limitations (e.g., degree of complexity, relevance of observations, mathematical form)
- Model inputs can vary significantly because of necessary judgment and differing assumptions
Users of valuations benefit when key information, assumptions, and limitations are disclosed to them. Then they can weigh the degree of reliability of the result and make their decision.
Businesses or fractional interests in businesses may be valued for various purposes such as mergers and acquisitions, sale of securities, and taxable events. An accurate valuation of privately owned companies largely depends on the reliability of the firm’s historic financial information. Public company financial statements are audited by Certified Public Accountants (USA), Chartered Certified Accountants (ACCA) or Chartered Accountants (UK and Canada) and overseen by a government regulator. Alternatively, private firms do not have government oversight—unless operating in a regulated industry—and are usually not required to have their financial statements audited. Moreover, managers of private firms often prepare their financial statements to minimize profits and, therefore, taxes. Alternatively, managers of public firms tend to want higher profits to increase their stock price. Therefore, a firm’s historic financial information may not be accurate and can lead to over- and undervaluation. In an acquisition, a buyer often performs due diligence to verify the seller’s information.
Financial statements prepared in accordance with generally accepted accounting principles (GAAP) show many assets based on their historic costs rather than at their current market values. For instance, a firm’s balance sheet will usually show the value of land it owns at what the firm paid for it rather than at its current market value. But under GAAP requirements, a firm must show the fair values (which usually approximates market value) of some types of assets such as financial instruments that are held for sale rather than at their original cost. When a firm is required to show some of its assets at fair value, some call this process “mark-to-market“. But reporting asset values on financial statements at fair values gives managers ample opportunity to slant asset values upward to artificially increase profits and their stock prices. Managers may be motivated to alter earnings upward so they can earn bonuses. Despite the risk of manager bias, equity investors and creditors prefer to know the market values of a firm’s assets—rather than their historical costs—because current values give them better information to make decisions.
There are commonly three pillars to valuing business entities: comparable company analyses, discounted cash flow analysis, and precedent transaction analysis.
Discounted cash flow method
Main article: Valuation using discounted cash flows
This method estimates the value of an asset based on its expected future cash flows, which are discounted to the present (i.e., the present value). This concept of discounting future money is commonly known as the time value of money. For instance, an asset that matures and pays $1 in one year is worth less than $1 today. The size of the discount is based on an opportunity cost of capital and it is expressed as a percentage or discount rate.
In finance theory, the amount of the opportunity cost is based on a relation between the risk and return of some sort of investment. Classic economic theory maintains that people are rational and averse to risk. They, therefore, need an incentive to accept risk. The incentive in finance comes in the form of higher expected returns after buying a risky asset. In other words, the more risky the investment, the more return investors want from that investment. Using the same example as above, assume the first investment opportunity is a government bond that will pay interest of 5% per year and the principal and interest payments are guaranteed by the government. Alternatively, the second investment opportunity is a bond issued by small company and that bond also pays annual interest of 5%. If given a choice between the two bonds, virtually all investors would buy the government bond rather than the small-firm bond because the first is less risky while paying the same interest rate as the riskier second bond. In this case, an investor has no incentive to buy the riskier second bond. Furthermore, in order to attract capital from investors, the small firm issuing the second bond must pay an interest rate higher than 5% that the government bond pays. Otherwise, no investor is likely to buy that bond and, therefore, the firm will be unable to raise capital. But by offering to pay an interest rate more than 5% the firm gives investors an incentive to buy a riskier bond.
For a valuation using the discounted cash flow method, one first estimates the future cash flows from the investment and then estimates a reasonable discount rate after considering the riskiness of those cash flows and interest rates in the capital markets. Next, one makes a calculation to compute the present value of the future cash flows.
Guideline companies method
Main article: Comparable company analysis
This method determines the value of a firm by observing the prices of similar companies (called “guideline companies”) that sold in the market. Those sales could be shares of stock or sales of entire firms. The observed prices serve as valuation benchmarks. From the prices, one calculates price multiples such as the price-to-earnings or price-to-book ratios—one or more of which used to value the firm. For example, the average price-to-earnings multiple of the guideline companies is applied to the subject firm’s earnings to estimate its value.
Many price multiples can be calculated. Most are based on a financial statement element such as a firm’s earnings (price-to-earnings) or book value (price-to-book value) but multiples can be based on other factors such as price-per-subscriber.
Net asset value method
The third-most common method of estimating the value of a company looks to the assets and liabilities of the business. At a minimum, a solvent company could shut down operations, sell off the assets, and pay the creditors. Any cash that would remain establishes a floor value for the company. This method is known as the net asset value or cost method. In general the discounted cash flows of a well-performing company exceed this floor value. Some companies, however, are worth more “dead than alive”, like weakly performing companies that own many tangible assets. This method can also be used to value heterogeneous portfolios of investments, as well as nonprofits, for which discounted cash flow analysis is not relevant. The valuation premise normally used is that of an orderly liquidation of the assets, although some valuation scenarios (e.g., purchase price allocation) imply an “in-use” valuation such as depreciated replacement cost new.
An alternative approach to the net asset value method is the excess earnings method. (This method was first described in the U.S. Internal Revenue Service‘s Appeals and Review Memorandum 34,[further explanation needed] and later refined by Revenue Ruling 68-609.) The excess earnings method has the appraiser identify the value of tangible assets, estimate an appropriate return on those tangible assets, and subtract that return from the total return for the business, leaving the “excess” return, which is presumed to come from the intangible assets. An appropriate capitalization rate is applied to the excess return, resulting in the value of those intangible assets. That value is added to the value of the tangible assets and any non-operating assets, and the total is the value estimate for the business as a whole. See Clean surplus accounting, Residual Income Valuation.
In the below cases, depending on context, Real options valuation techniques are also sometimes employed, if not preferred; for further discussion here see Business valuation #Option pricing approaches, Corporate finance #Valuing flexibility.
Valuation of a suffering company
When valuing “distressed securities“, in many cases the company in question is valued using real options analysis – see Business valuation #Option pricing approaches. This value serves to complement (or sometimes replace) the more standard techniques. When these latter are applied, various adjustments are typically made to the valuation result; this would be true whether market-, income-, or asset-based. These adjustments would consider
- Lack of marketability discount of shares
- Control premium or lack of control discount
- Excess or restricted cash
- Other non-operating assets and liabilities
- Above- or below-market leases
- Excess salaries in the case of private companies
The financial statements here are similarly recast, including adjustments to working capital, deferred capital expenditures, cost of goods sold, Non-recurring professional fees and costs, and certain non-operating income/expense items
Valuation of a startup company
Startup companies such as Uber, which was valued at $50 billion in early 2015, are assigned post-money valuations based on the price at which their most recent investor put money into the company. The price reflects what investors, for the most part venture capital firms, are willing to pay for a share of the firm. They are not listed on any stock market, nor is the valuation based on their assets or profits, but on their potential for success, growth, and eventually, possible profits. Many startup companies use internal growth factors to show their potential growth which may attribute to their valuation. The professional investors who fund startups are experts, but hardly infallible, see Dot-com bubble.
Valuation of intangible assets
Valuation models can be used to value intangible assets such as for patent valuation, but also in copyrights, software, trade secrets, and customer relationships. Since few sales of benchmark intangible assets can ever be observed, one often values these sorts of assets using either a present value model or estimating the costs to recreate it. Regardless of the method, the process is often time-consuming and costly.
Valuations of intangible assets are often necessary for financial reporting and intellectual property transactions.
Stock markets give indirectly an estimate of a corporation’s intangible asset value. It can be reckoned as the difference between its market capitalisation and its book value (by including only hard assets in it).
Valuation of mining projects
In mining, valuation is the process of determining the value or worth of a mining property. Mining valuations are sometimes required for IPOs, fairness opinions, litigation, mergers and acquisitions, and shareholder-related matters. In valuation of a mining project or mining property, fair market value is the standard of value to be used.
The CIMVal Standards (“Canadian Institute of Mining, Metallurgy and Petroleum on Valuation of Mineral Properties”) are a recognised standard for valuation of mining projects and is also recognised by the Toronto Stock Exchange. The standards  stress the use of the cost approach, market approach, and the income approach, depending on the stage of development of the mining property or project. see also Mineral economics in general.