CORPORATE FINANCE FINANCIAL ANALYSIS
What Is Valuation?
By JAMES CHEN Updated May 31, 2024
Reviewed by DAVID KINDNESS
Fact checked by PATRICE WILLIAMS
Part of the Series
How to Value a Company
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.
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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 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.
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Understanding Valuation
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.
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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
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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.
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.
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.
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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.
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 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.
FAST FACT
In investments, a comparables approach is often synonymous with
relative valuation.
Sometimes doing all of these and then weighing each is appropriate to
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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.
Important: DCF approaches to valuation are used in pricing stocks,
such as with dividend discount models like the Gordon growth
model.
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.
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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, which 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.
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
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historical multiples to calculate intrinsic value.
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.
Those interested in learning more about valuation and other financial topics
may want to consider enrolling in one of the best personal finance classes.
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What Is an Example of Valuation?
A common example of valuation is a company's market capitalization. This
takes the share price of a company and multiplies it by the total shares
outstanding. For example, if a company's share price is $10, and the company
has 2 million shares outstanding, its market capitalization would be $20 million.
How Do You Calculate Valuation?
There are many ways to calculate valuation and will differ on what is being
valued and when. A common calculation in valuing a business involves
determining the fair value of all of its assets minus all of its liabilities. This is an
asset-based calculation.
What Is the Purpose of Valuation?
The purpose of valuation is to determine the worth of an asset or company and
compare that to the current market price. This is done so for a variety of
reasons, such as bringing on investors, selling the company, purchasing the
company, selling off assets or portions of the business, the exit of a partner, or
inheritance purposes.
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The Bottom Line
Valuation is the process of determining the worth of an asset or company.
Valuation is important because it provides prospective buyers with an idea of
how much they should pay for an asset or company and for prospective sellers,
how much they should sell for.
Valuation plays an important role in the M&A industry, as well as in regard to the
growth of a company. There are many valuation methods, all of which come
with their pros and cons.
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Part of the Series
How to Value a Company
Introduction to Company Valuation
1 Valuing a Company: Business Valuation Defined With 6 Methods
2 Valuation
CURRENT ARTICLE
3 Valuation Analysis
NEXT UP
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Financial Statements
Financial Ratios
Fundamental Analysis Basics
Fundamental Analysis Tools and Methods
Valuing Non-Public Companies
Related Terms
Relative Valuation Model: Definition, Steps, and Types of
Models
A relative valuation model is a business valuation method that compares a firm's value to
that of its competitors to determine the firm's financial worth. more
Multiples Approach: Definition and Example
The multiples approach is a valuation theory based on the idea that similar assets sell at
similar prices. more
What Is Asset Valuation? Absolute Valuation Methods, and
Example
Asset valuation is the process of determining the fair market value of assets. more
Absolute Value: Definition, Calculation Methods, Example
Absolute value is a measure of a company's or asset's intrinsic value. more
Deflationary Spiral: Overview and Examples in Government
Spending
The multistage dividend discount model is an equity valuation model that builds on the
Gordon growth model by applying varying growth rates to the calculation. more
P/E Ratio Definition: Price-to-Earnings Ratio Formula and
:
Examples
The price-to-earnings (P/E) ratio measures a company's current share price relative to its
per-share earnings. more
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