Valuation analysis is used to evaluate the potential merits of an investment or to objectively assess the value of a business or asset. Valuation analysis is one of the core duties of a fundamental investor, as valuations (along with cash flows) are typically the most important drivers of asset prices over the long term.
Valuation analysis should answer the simple yet vital question: what is something worth? The analysis is then based on either current data or projections of the future.
In this section, we'll consider how companies can value any projects they're considering to determine whether they are worth undertaking. (For related reading, see 5 Crazy Corporate Valuations That Proved Too Low and Valuing Private Companies.)
For the purposes of this lesson, projects can be divided into two categories:
1. Expansion projects are projects companies invest in to expand the business's earnings.
2. Replacement projects are projects companies invest in to replace old assets and maintain efficiencies.
Determining a Project's Cash Flows
When beginning capital-budgeting analysis, it is important to determine the cash flows of a project. These cash flows can be segmented as follows:
1. Initial Investment Outlay
These are the costs that are needed to start the project, such as new equipment, installation, etc.
2. Operating Cash Flow over a Project's Life
Scenario / What-If Analysis
This is the additional cash flow a new project generates.
3. Terminal-Year Cash Flow
This is the final cash flow, both the inflows and outflows at the end of the project's life, such as potential salvage value at the end of a machine's life.