In finance, valuation is the process of estimating the market value of a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as
stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., Bonds issued by a company). Valuations are required in many contexts including investment analysis, capital budgeting, merger and acquisition transactions,
financial reporting, taxable events to determine the proper tax liability, and in litigation.
Asset valuation
Valuation of financial assets is done using one or more of these types of models:
- Relative value models determine the value based on the market prices of similar
assets.
- Absolute value models determine the value by estimating the expected future earnings from
owning the asset discounted to their present value.
- Option pricing models are used for certain types of financial assets (e.g., warrants, put options, call
options, employee stock options, investments with embedded options such as a callable bond) and are a complex present
value model. The most common option pricing models are the Black-Scholes-Merton models and
lattice models.
Common terms for the value of an asset or liability are fair market value,
fair value, and intrinsic value. The
meanings of these terms differ. The most common term is fair market value defined as the cash price an item would sell for
between a willing buyer and willing seller assuming they both have knowledge of the relevant facts and they have no compulsion to
buy or sell. Fair value is used in different contexts and has multiple meanings. Some people use the term to mean the same thing
as fair market value. Fair value is also a term used in accounting and law. It is used in generally accepted accounting principles (GAAP) for financial reporting and in
law in shareholder rights legal statutes. In these cases, fair value is defined in the accounting literature or the law,
respectively. Fair value may be different from fair market value in the accounting and legal contexts. Intrinsic value is an
asset's true value regardless of the market price. When an analyst determines a stock's intrinsic value is greater than its
market price, the analyst issues a "buy" recommendation and vice versa. The determination of intrinsic value may be subject to
personal opinion and vary among individual analysts.
For a comprehensive discussion on financial valuation see Aswath Damodaran,
Investment Valuation, (New York: John Wiley & Sons, 2002).
Business valuation
Businesses or fractional interests in businesses may be valued for various purposes such as
mergers and acquisitions, sale of securities, and taxable events. An accurate valuation of privately owned companies largely
depends on the reliability of the company's financial information. Public company
financial statements are audited by Certified Public Accountants (US),
Chartered Certified Accountants (ACCA) or Chartered
Accountants (UK and Canada) and overseen by a government regulator. Private companies do not have government oversight and
are generally not required to have their financial statements audited. Private company financial statements are commonly prepared
to minimize taxes by lowering taxable income and the financial information may not be accurate. Public companies tend to want
higher earnings to increase their share prices. Inaccurate financial information can lead to over- and undervaluation. In an
acquisition, due diligence is commonly performed by the buyer to validate the
representations made by the seller.
Financial statements prepared in accordance with generally accepted accounting principles (GAAP) usually express the values of
the assets at their costs rather than their higher market values. For example, the balance
sheet would reflect a piece of land at the purchase price rather than its appreciated value. Certain types of assets and
liabilities such as securities held for sale will be reflected at their market values rather than their costs so that the
company's financial information is more meaningful. This process is called "mark-to-market" but is subject to manager bias who may be compensated more with higher values. An extreme
example of a company taking advantage of mark-to-market accounting to pump their own share price was Enron.
Business valuation methods
Discounted cash flows method
-
A method for determining the current value of a company using future cash flows adjusted for time value. The future cash flow
set is made up of cash flows within the determined forecast period and a continuing value that represents a steady state cash
flow stream after the forecast period, known as the Terminal Value.
Multiples method
-
A method for determining the current value of a company by using a sample of ratios from comparable peer groups. The specific
ratio to be used depends on the objective of the valuation. The valuation could be designed to estimate the value of the
operation of the business or the value of the equity of the business. When calculating the value of the operation the most
commonly used ratio is the EBITDA multiple, which is the ratio of EBITDA (Earnings Before Interest Taxes Depreciation and
Amortization) to the Enterprise Value (Equity Value plus Debt Value). When valuing the equity of a company, the most widely used
multiple is the Price Earnings Ratio (PER) of stocks in a similar industry, which is the ratio of Stock price to Earnings per
Share of any public company. Using the sum of multiple PER’s improves reliability but it can still be necessary to correct the
PER for current market conditions.
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 e.g., 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 (for example, within large financial firms including investment banks and stockbrokers).
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. 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.
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-cashflow 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.
It is very important to note that valuation is more an art than a science because it requires judgement:
- There are very different situations and purposes in which you value an asset (e.g. company in distress, tax purposes, mergers
& acquisitions, quarterly reporting). In turn this requires different methods or a different interpretation of the same
method each time.
- All valuation models and methods have their limitations (e.g., mathematical, complexity, simplicity, comparability) and could
be widely criticized. As a general rule the valuation models are most useful when you use the same valuation method as the
"partner" you are interacting with. Mostly the method used is industry or purpose specific;
- The quality of some of the input data may vary widely
- In all valuation models there are a great number of assumptions that need to be made and things might not turn out the way
you expect. Your best way out of that is to be able to explain and stand for each assumption you make;
When a valuation is prepared all assumptions should be clearly stated, especially the context. It is improper, for example, to
value a going concern, based on an assumption that it is going out of business, since then only a salvage value remains.
Valuation of Intangibles
Financially-sound valuation methods may also be applied to assets other than financial instruments. Historically, there has
been a lot of difficulty valuing critical quantities like improved customer relations, product quality, risk avoidance, and so
on. In such cases, methods like Applied Information Economics are used to
convert intangible factors and uncertain quantities into financially meaningful terms.
Valuation of mining projects
In mining, valuation is the process of determining the value or worth of a mining
property.
Mining valuations are sometimes required for IPO's, fairness opinions, litigation, mergers & acquisitions and shareholder
related matters.
In valuation of a mining project or mining property, fair market value is the standard of value to be used. The CIMVal
Standards are a recognised standard for valuation of mining projects and is also recognised by the Toronto Stock Exchange
(Venture). The standards spearheaded by Spence & Roscoe, stress the use of the cost approach, market approach and the income
approach, depending on the stage of development of the mining property or project.
Asset pricing models
See also Modern portfolio theory
See also
References
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