What is Valuation and How to Do It

Introduction

Valuation is the process of estimating the economic value of a business or asset. The purpose of valuation is to determine a fair market value, which can be used for a variety of decisions, such as seeking investment or a purchase or sale. Determining a value can be complex and must be done through a thorough analysis of the company’s assets, liabilities and potential.

Valuation techniques are the tools used for valuation, including the use of financial models, comparison to other market transactions, and the application of discounted cash flow analysis. Below, we will provide an overview of the different types of valuation techniques.

Discounted Cash Flow

Discounted Cash Flow (DCF) is a process used to evaluate the current worth of a company by investigating its projected cash flows. It takes into consideration the time value of money and adjusts the expected future cash flows to their present worth, accounting for any opportunity costs.

Benefits

The cash flow of a company not only includes the actual cash flows generated, but also factors in any potential risks. DCF is beneficial because it factors in all of these elements, making it more comprehensive than other methodologies. Furthermore, this valuation method can provide insight into the company’s projected financial health rather than simply relying on historical information.

Examples

• Hurdle rate: This is the rate of return a company must reach or exceed in order to justify future venture or investment.
• Beta Analysis: Beta is a measure of volatility, or systematic risk, for a particular security or portfolio compared to the market as a whole.
• Discount rate: The discount rate used for discounted cash flow analysis is the internal rate of return required by investors for their investments.
• WACC: Weighted average cost of capital is the rate used to discount future cash flows to the present value using the associated risk of those future returns.

Comparable Company Analysis

Comparable company analysis is a financial valuation method that looks at other companies that are similar to the one being valued in order to determine the potential value. It is used to evaluate both private and public companies, with public companies often used as comparison points. It is important to select companies that have similar levels of risk, size, industry, and assets.

Definition

Comparable company analysis is a type of relative valuation method, meaning it looks at other companies in order to determine the value of the one being evaluated. This approach uses multiples, such as the price-to-earnings ratio or the price-to-book ratio, to compare a subject company’s metrics to similar competing companies. By considering metrics from a variety of comparable public companies, the analyst can then determine a range of values for the subject company based on how different variables affect its value.

Benefits

One of the primary benefits of a comparable company analysis is that it allows an analyst to make quick and accurate estimates of a company’s value. It is easy to compare companies to make sure that the subject company is not being overvalued or undervalued. Additionally, the multiples used to compare companies can be adjusted to account for differences in size, risk, and liquidity.

Examples

A common example of a comparable company analysis is the price-to-earnings ratio. This ratio compares the earnings of a company to its stock price. By looking at the public companies in the same industry, an analyst can determine the range of values for the company being valued. Additionally, the analyst can use other metrics, such as the enterprise value-to-sales ratio and the market capitalization-to-sales ratio, to compare the subject company and its competitors.

Another example of a comparable company analysis is the price-to-book ratio. This metric compares a company’s stock price to its book value. By comparing this ratio of the subject company and its peers, an analyst can determine if the stock is undervalued or overvalued and make an accurate estimate of its value.

Precedent Transactions

Precedent transactions are a valuation technique used to calculate the fair market value of a business based on comparable sales of similar businesses. The approach is used most often in situations that involve specific and unique types of businesses where there is not a large population of transactions or transactions available to use in a discounted cash flow analysis.

Definition

In the context of business valuations, a precedent transaction is a sale of an operating business in the same industry or market that is used as a source of comparison for a target business. It provides an insight into the type of returns that buyers will pay for businesses of a similar type. Precedent transactions provide an estimate of value by analyzing the price paid for a comparable business.

Benefits

Using precedent transactions for valuation has several advantages. It is often a quicker and more accurate method for determining the value of a business. Because the technique relies on readily available market data, it is less costly than other forms of valuation. It can also be used in situations where a full discounted cash flow analysis is not feasible. Precedent transactions provide an effective way to estimate the value of a business compared to alternatives.

Examples

A few examples of precedent transactions are:

• The sale of a restaurant in a mid-sized city based on the sales of similar restaurants
• The sale of a software company based on the sales of other companies with similar products
• The sale of a medical device manufacturer based on the sales of other medical device companies

Asset Valuation

Asset valuation is the process of estimating the economic value of an asset. It is used to help individuals and companies determine whether a particular asset is worth investing in or not. Assets can include stocks, bonds, real estate, and more.

Definition

Asset valuation is based on the fundamental concept that an asset’s value is derived from its expected future cash flows. An asset’s value is calculated by estimating the total expected cash flows (discounted back to their present value) over the life of the asset. By taking into account factors such as inflation, taxes, and market risk, asset valuation is able to provide an estimate of an asset’s market value.

Benefits

Asset valuation has many important benefits. It allows individuals and companies to make informed decisions about which assets to invest in, as well as when to buy and sell them. Additionally, asset valuation is a critical part of financial planning and can help individuals plan for retirement, maximize the value of their portfolio, and more.

Examples

Asset valuation is used in many different situations. For example, it can be used to:

• Evaluate a business before making an investment
• Determine the value of a company for sale
• Estimate the value of assets for estate planning
• Calculate the selling price of a property
• Assess the market value of a company or an individual asset

Options Pricing Model

Options pricing model is a type of pricing model used in the valuation of a company. It is based on the Black-Scholes model, which takes various factors into account, such as the volatility of the security, the time to expiration, the current stock price and the exercise price of the option. By utilizing these variables, the options pricing model produces a theoretical value of the option for a given stock.

Definition

Options pricing model is a method of determining the theoretical value of a stock option by utilizing the equations from the Black-Scholes model. This model takes into account the current market price of the security, the time to expiration of the option, the volatility of the security and the exercise price of the option to determine the value of the option.

Benefits

The options pricing model is a great tool for valuing a company, as it helps to accurately estimate the theoretical value of the stock option and provide an accurate view of the value of the company. Additionally, the options pricing model can be used to analyze the potential risk associated with investing in the company, as it takes into account various factors that can influence the value of the stock.

Examples

One example of an options pricing model is the Black-Scholes model. This model takes into account the current stock price of the company, the time to expiration of the option, the exercise price of the option, and the volatility of the security. This model can then be used to estimate the theoretical value of the option, which can be used to determine the value of the company.

Another example of an options pricing model is the Binomial model. This model is an extension of the Black-Scholes model, and is used to evaluate the value of an option based on the underlying stock or asset price. The Binomial model is useful for valuing complex options that have multiple underlying assets or securities. This model utilizes the variables from the Black-Scholes model and produces a more accurate estimation of the theoretical value of the option.

Conclusion

Valuation techniques are essential for any investor or professional looking to understand the value and potential of a business or asset. Valuation techniques are also essential for businesses that are preparing for a sale of equity or a merger and need to establish a fair market value of their business. Understanding the various types of valuation techniques can be a valuable tool in any investor’s or entrepreneur’s toolkit.

Summary of Valuation Techniques

Valuation techniques can be divided into two broad categories: intrinsic and relative. Intrinsic methods are focused on the fundamental characterization of an asset or business. These include comparative, discounted cash flow, and asset-based approaches. Relative methods, on the other hand, compare the price of the asset or business to that of similar companies or assets. Relative methods include price/earnings ratio, marketable security approach, comparable multiple approach, and transaction comparable approach.

Points to Remember

• It is important to understand which type of valuation technique is most applicable to your situation based on the specific circumstances.
• Each valuation technique has its own set of assumptions, and it is important to be aware of these assumptions before using the technique.
• When valuing a business or asset, it is important to be aware of all potential external factors, such as the current economic climate, industry trends, and more.

Resources for Further Reading

For more information on the various types of valuation techniques, here are some resources for further reading:

• Financial Analysis and Valuation for Strategic Decision Making by Mary Lea McAnally
• Valuation: Measuring and Managing the Value of Companies by McKinsey & Company
• Valuation: The Art and Science of Corporate Investment Decisions by Damodaran