Valuation
What is valuation?
Valuation is the analytical process of determining the present market value of a company, property or asset. Company valuation calculations are time-specific and non-negotiable, and ordinarily include the worth of everything of economic value the company owns - including equipment, property, records when you build an online store, liquid assets, patents, trademarks, etc.
Basic principles of valuation
The following make up the difference principles of valuation. These tend to remain consistent, even if the method or approach towards valuation used, varies.
Cash flow
Valuation is often based on the expected future cash flows generated by an asset. Cash flow refers to the money generated by the investment over time, such as revenues, earnings, or dividends.
Time value of money
This refers to the principle that a dollar received in the future is worth less than a dollar received today due to factors like inflation and the opportunity cost of capital. Valuation considers the timing and risk associated with future cash flows, discounting them to their present value.
Risk and return
Valuation takes into account the risk associated with an investment or asset. Higher-risk investments typically require higher rates of return to compensate investors. Valuation models incorporate risk assessment through discount rates or required rates of return.
Comparable analysis
Valuation often involves comparing the asset being valued to similar assets in the market. By analyzing comparable assets or companies, valuation practitioners can derive an estimate of value based on the market's perception of similar investments.
Market efficiency
Valuation assumes that markets are generally efficient and reflect all available information. This principle recognizes that the price of an asset in the market is a reflection of its value, and valuation aims to estimate this intrinsic value based on available information.
Fundamental analysis
Valuation considers the fundamental characteristics and financial performance of the asset or business being valued. This includes analyzing financial statements, industry trends, competitive advantages, growth prospects, and other relevant factors that can influence value.
Purpose and context
Valuation is influenced by the purpose for which it is conducted. Different purposes, such as mergers and acquisitions, financial reporting, taxation, or investment decisions, may require specific approaches and considerations.
It's important to note that valuation is considered both an art and a science, and different approaches may be appropriate depending on the asset or industry being valued. Professional valuation practitioners often employ a combination of these principles and various other valuation methods to arrive at a reasonable estimate of value.
What is the purpose of valuation?
The purpose of valuation is to compare the calculated value of the business or asset to that of others in the same industry and the current market price. Due to the intricacies and challenges of such calculations, valuations are reserved for a series of specific situations such as raising equity capital or selling the business.
Other common reasons why one may choose to have a business valued include:
Establishing partner ownership percentages
Creating an internal shares market
Merge or acquire another company
Improve the business’s value (real or perceived)
Adding shareholders to the board
Planning your business development and business growth
Benefits of using valuation
When used as part of a comprehensive business development strategy, valuation can deliver the following benefits:
Better decision-making. Valuation provides businesses with accurate data that they can use to make informed decisions about investments and assets. This should help them plan for their future growth better.
Improved financial performance. Valuation helps businesses to identify undervalued assets and opportunities for growth, which can lead to increased profitability over the long term.
Increased credibility. Accurate valuation reports can improve a business's credibility with investors, lenders, and other stakeholders. This also contributes to the long term health and growth of a business.
Facilitates mergers and acquisitions when relevant. Valuation is essential in mergers and acquisitions, helping businesses to determine the fair value of assets and liabilities involved in transactions and sales.
You may also be interested in:
Most common valuation methods
There are numerous different methods for calculating a company valuation, as the parameters taken into account depend on the purpose of the said valuation. Among the many models available, here are the three most commonly used ones:
01. Comparable analysis
The simplicity of comparable analysis makes it the most widely used company valuation method. This model consists of finding a group of businesses sharing similar metrics and presuming that their average price should be comparable to the company that is being valued. The metrics taken into consideration may vary from case to case, but generally include industry and area of operation as well as financial statistics.
02. Discounted cash flow analysis
Also known as income approach, the discounted cash flow (DCF) is performed by compiling a financial model that estimates the total value of its projected cash flow and then adjusts it to find the present value of that cash. The extensive amount of detail and data analysis required by the DCF model makes it one of the most detailed and accurate company validation methods.
03. Precedent transaction analysis
Much like comparable analysis, the precedent transaction analysis also uses comparison patterns to estimate the valuation of a company in a quick and efficient manner. In this case, the model focuses on businesses similar to the one being valued that have been bought or sold, and uses their exit pricing as a guidance to decide the target company valuation.
Stages of valuation
In general a valuation process will follow the below flow:
Defining the purpose
Clearly defining the purpose of the valuation, whether it is for mergers and acquisitions, financial reporting, taxation, investment analysis, or other specific needs. The purpose determines the scope and method of the valuation.
Gathering information
Collecting relevant information about the asset or business being valued. This includes financial statements, historical data, industry and market information, legal documents, and any other data that can provide insights into what drives value and potential risk factors.
Selecting the valuation method
Determining the appropriate valuation methods based on the asset's characteristics, industry norms, and purpose of the valuation. Common methods include discounted cash flow (DCF), market multiples, comparable transactions, asset-based valuation, and option pricing models.
Analyzing financials
This means conducting a detailed analysis of financial statements, including income statements, balance sheets, and cash flow statements. Identifying trends, key performance indicators, and any adjustments needed to normalize the financial data for valuation purposes.
Forecasting future cash flow
Developing projections of future cash flows, considering factors such as revenue growth, operating expenses, capital expenditures, and working capital requirements. These projections form the basis for many valuation methods, such as the DCF approach.
Determining discount rate
Assessing the appropriate discount rate or required rate of return to account for the time value of money and the risk associated with the investment. The discount rate reflects the investor's expected return and the riskiness of the asset compared to alternative investments.
Adjustments
Making necessary adjustments to the estimated value to account for specific factors such as control premiums, minority interest discounts, marketability discounts, or other relevant adjustments based on the purpose and context of the valuation.
Reviewing and validating
Reviewing the valuation results, assumptions, and methodologies to ensure they are logical, consistent, and in line with applicable standards or guidelines. Validating the results through sensitivity analysis or benchmarking against similar assets or market data.
Documenting
Preparing a comprehensive valuation report that documents the methodology, assumptions, data sources, and conclusions. Communicate the findings and conclusions clearly and effectively to the intended audience, such as clients, stakeholders, or regulatory authorities.
Valuation in practice
Valuation is used in various industries and contexts, some potential scenarios include:
Real estate business, where valuation helps property owners and investors to determine the fair market value of their properties.
Finance business, here, valuation is used to determine the value of stocks, bonds, and other financial instruments.
Startup companies, where valuation is important for startups looking to raise capital from investors or venture capitalists when starting a business.
Valuation measurements
Valuation ratios are financial metrics used to assess the relative value of a company's stock or asset. They might also be referred to as valuation measurements. These ratios compare the market price of the asset to a specific financial measure, such as earnings, cash flow, or book value.
The formulas for some commonly used valuation ratios are as follows:
Price-to-Earnings (P/E) Ratio: P/E ratio = Market price per share / Earnings per share
Price-to-Sales (P/S) Ratio: P/S ratio = Market price per share / Sales per share
Price-to-Book (P/B) Ratio: P/B ratio = Market price per share / Book value per share
Enterprise Value-to-EBITDA (EV/EBITDA) Ratio: EV/EBITDA ratio = Enterprise value / EBITDA
Price-to-Cash Flow (P/CF) Ratio: P/CF ratio = Market price per share / Cash flow per share
Dividend Yield: Dividend yield = Dividend per share / Market price per share
It's important to note that these formulas represent simplified versions of valuation ratios. Depending on the context, there may be variations or additional factors considered in the calculation of these. Also, different industries or sectors may have specific valuation ratios that are more relevant to their assets and characteristics.