Valuation (finance)


In finance, valuation is the process of determining the value of a investment, asset, or security.
Generally, there are three approaches taken, namely discounted cashflow valuation, relative valuation, and contingent claim valuation.
Valuations can be done for assets
or for liabilities.
Valuation is a subjective exercise, and in fact, the process of valuation itself can also affect the value of the asset in question.
Valuations may be needed for various reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability.
In a business valuation context, various techniques are used to determine the price that a third party would pay for a given company;
while in a portfolio management context, stock valuation is used by analysts to determine the price at which the stock is fairly valued relative to its projected and historical earnings, and to thus profit from related price movement. Valuation refers to the analytical process of determining the economic value of an asset, business, security, or liability. It is commonly used in the fields of accounting, finance, economics, and investment analysis. Valuation helps in making informed decisions related to investment, mergers and acquisitions, financial reporting, taxation, and dispute resolution
Valuation is carried out for a variety of purposes, including investment analysis, financial reporting, taxation, mergers and acquisitions, restructuring, and legal disputes. Investors use valuation to assess whether an asset or security is overvalued or undervalued, while companies rely on valuation for strategic decision-making and compliance with accounting standards.

Valuation overview

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 than its market price, an analyst makes a "buy" 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:
  1. Absolute value models 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. These models rely on mathematics rather than price observation. See.
  2. 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 / revisit the intrinsic valuation. See.
  3. 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, lattice models and Monte Carlo simulations. This approach is sometimes referred to as contingent claim valuation, in that the value will be contingent on some other asset. See.

    Usage

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-market estimates 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.
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 and this generates valuation risk. 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. Another intangible asset, data, is increasingly being recognized as a valuable asset in the information economy.
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.
Valuation requires judgment and assumptions:
  • There are different circumstances and purposes to value an asset. Such differences can lead to different valuation methods or different interpretations of the method results
  • All valuation models and methods have limitations
  • 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.

Business valuation

es or fractional interests in businesses may be valued for various purposes such as mergers and acquisitions, sale of securities, and taxable events. When correct, a valuation should reflect the capacity of the business to match a certain market demand, as it is the only true predictor of future cash flows. 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, Chartered Certified Accountants or Chartered Accountants, and Chartered Professional Accountants 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 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 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. Business valuation credentials include the Chartered Business Valuator offered by the CBV Institute, ASA and CEIV from the American Society of Appraisers, and the CVA by the National Association of Certified Valuators and Analysts.

Discounted cash flow method

This method estimates the value of an asset based on its expected future cash flows, which are discounted to the present. 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.