Loading the player...

What is a 'Valuation'

Valuation is the process of determining the current 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 company's management, the composition of its capital structure, the prospect of future earnings, and the market value of assets.

BREAKING DOWN '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. 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 over- or undervalued by the market.  

How Earnings Impact Valuation

The earnings per share (EPS) formula is stated as earnings available to common shareholders divided by 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 to other companies in the same industry and to 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 to similar companies and historical multiples to calculate intrinsic value. 

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 of 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 Methods

There are various ways 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 the a company to similar companies 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 weighting 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 little assets, instead, an earnings based approach like the DCF would be more appropriate.  

RELATED TERMS
  1. Business Valuation

    Business valuation is the process of determining the economic ...
  2. Asset Valuation

    Asset valuation is the process of determining the fair market ...
  3. Relative Valuation Model

    A relative valuation model is a business valuation method that ...
  4. Terminal Value (TV)

    Terminal value is the value of a bond at maturity or of an asset ...
  5. Valuation Analysis

    A valuation analysis is a process to estimate the approximate ...
  6. Appraisal Right

    An appraisal right is the right to determine a fair stock price ...
Related Articles
  1. Investing

    Discounted Cash Flow (DCF)

    Discover how investors can use this valuation method to determine the intrinsic value of a stock.
  2. Investing

    Value Investing: Why Investors Care About Free Cash Flow Over EBITDA

    Examine value investing philosophy and methodology to see why free cash flow is more important than EBITDA in pure intrinsic value calculation.
  3. Investing

    Top Reasons IPO Valuations Miss The Mark (MS, ZNGA)

    The costly services of investment banks don’t necessarily guarantee accuracy in IPO pricing.
  4. Small Business

    Valuing Startup Ventures

    Valuing a company is a difficult task, regardless of the size of the business - but these methods can help.
  5. Investing

    Here's How Relative Valuation Can Be a Trap

    Valuing a company through relative valuation to identify low-priced companies with strong fundamentals can make for deceiving looking bargain stocks.
  6. Personal Finance

    Discounted cash flows or comparables: Which to use

    DCF and comparables models are widely used in equity valuation, and here we'll explain the pros and cons of each method.
  7. Investing

    Learn to Value Real Estate Investment Property

    Make sure you know what your real estate investment is worth before you sign the ownership papers. Learn what capitalization rate means to your net operating income.
  8. Investing

    Peer Comparison Uncovers Undervalued Stocks

    Learn how to put one of the top equity analysis tools to work for you.
  9. Investing

    What Is The Intrinsic Value Of A Stock?

    Intrinsic value can be subjective and difficult to estimate. It’s a perception of a security’s value that factors tangible and intangible factors.
RELATED FAQS
  1. Intrinsic Value vs Current Market Value

    Discover the differences between intrinsic and market values, what makes the former difficult to determine, and how investor ... Read Answer >>
  2. How do you use DCF for real estate valuation?

    Learn how discounted cash flow analysis is used for real estate valuation and the various factors that go into calculating ... Read Answer >>
  3. When and why should the terminal value be discounted?

    Find out why investors use the terminal value, why the terminal value is discounted to the present day, and how it's related ... Read Answer >>
  4. What is the difference between enterprise value and equity value?

    Valuating a business accurately depends heavily on the purpose of the valuation. Learn how enterprise value and equity value ... Read Answer >>
  5. What value metrics are best for analyzing companies in the metals and mining sector?

    Learn what some of the best valuation measures are that analysts commonly use to evaluate companies in the metals and mining ... Read Answer >>
Hot Definitions
  1. Yield Curve

    A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but ...
  2. Portfolio

    A portfolio is a grouping of financial assets such as stocks, bonds and cash equivalents, also their mutual, exchange-traded ...
  3. Gross Profit

    Gross profit is the profit a company makes after deducting the costs of making and selling its products, or the costs of ...
  4. Diversification

    Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
  5. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  6. Current Assets

    Current assets is a balance sheet item that represents the value of all assets that can reasonably expected to be converted ...
Trading Center