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In finance, valuation is the process of determining the value of a (potential) investment, asset, or security. Generally, there are three approaches taken, namely discounted cashflow valuation, relative valuation, and contingent claim valuation.
Valuations can be done for (for example, investments in marketable securities such as companies' share capital and related rights, business enterprises, or such as , Data valuation and ) or for liabilities (e.g., bonds issued by a company). Valuation is a subjective exercise, and in fact, the process of valuation itself can also affect the value of the asset in question.
Valuations may be needed for various reasons such as investment analysis, capital budgeting, merger and Takeover transactions, financial reporting, taxable events to determine the proper tax liability. In a business valuation context, various techniques are used to determine the (hypothetical) price that a third party would pay for a given company; while in a portfolio management context, stock valuation is used by analysts to determine the price at which the stock is fairly valued relative to its projected and historical earnings, and to thus profit from related price movement.
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 and this generates valuation risk. 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. Another intangible asset, Data valuation, is increasingly being recognized as a valuable asset in the information economy.
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-cash-flow and present value calculations, and analyses of bonds that focus on credit ratings, assessments of default risk, risk premium, 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.
Valuation requires judgment and assumptions:
Users of valuations benefit when key information, assumptions, and limitations are disclosed to them. Then they can weigh the degree of reliability of the result and make their decision.
Financial statements prepared in accordance with generally accepted accounting principles (GAAP) show many assets based on their historic costs rather than at their current market values. For instance, a firm's balance sheet will usually show the value of land it owns at what the firm paid for it rather than at its current market value. But under GAAP requirements, a firm must show the fair values (which usually approximates market value) of some types of assets such as financial instruments that are held for sale rather than at their original cost. When a firm is required to show some of its assets at fair value, some call this process "mark-to-market". But reporting asset values on financial statements at fair values gives managers ample opportunity to slant asset values upward to artificially increase profits and their stock prices. Managers may be motivated to alter earnings upward so they can earn bonuses. Despite the risk of manager bias, equity investors and creditors prefer to know the market values of a firm's assets—rather than their historical costs—because current values give them better information to make decisions.
There are commonly three pillars to valuing business entities: comparable company analyses, discounted cash flow analysis, and precedent transaction analysis. Business valuation credentials include the Chartered Business Valuator (CBV) offered by the CBV Institute, ASA and CEIV from the American Society of Appraisers, and the CVA by the National Association of Certified Valuators and Analysts.
In finance theory, the amount of the opportunity cost is based on a relation between the risk and return of some sort of investment. Classic economic theory maintains that people are rational and averse to risk. They, therefore, need an incentive to accept risk. The incentive in finance comes in the form of higher expected returns after buying a risky asset. In other words, the more risky the investment, the more return investors want from that investment. Using the same example as above, assume the first investment opportunity is a government bond that will pay interest of 5% per year and the principal and interest payments are guaranteed by the government. Alternatively, the second investment opportunity is a bond issued by small company and that bond also pays annual interest of 5%. If given a choice between the two bonds, virtually all investors would buy the government bond rather than the small-firm bond because the first is less risky while paying the same interest rate as the riskier second bond. In this case, an investor has no incentive to buy the riskier second bond. Furthermore, in order to attract capital from investors, the small firm issuing the second bond must pay an interest rate higher than 5% that the government bond pays. Otherwise, no investor is likely to buy that bond and, therefore, the firm will be unable to raise capital. But by offering to pay an interest rate more than 5% the firm gives investors an incentive to buy a riskier bond.
For a valuation using the discounted cash flow method, one first estimates the future cash flows from the investment and then estimates a reasonable discount rate after considering the riskiness of those cash flows and interest rates in the capital markets. Next, one makes a calculation to compute the present value of the future cash flows.
Many price multiples can be calculated. Most are based on a financial statement element such as a firm's earnings (price-to-earnings) or book value (price-to-book value) but multiples can be based on other factors such as price-per-subscriber.
An alternative approach to the net asset value method is the excess earnings method. (This method was first described in the U.S. Internal Revenue Service's Appeals and Review Memorandum 34, and later refined by Revenue Ruling 68-609.) The excess earnings method has the appraiser identify the value of tangible assets, estimate an appropriate return on those tangible assets, and subtract that return from the total return for the business, leaving the "excess" return, which is presumed to come from the intangible assets. An appropriate capitalization rate is applied to the excess return, resulting in the value of those intangible assets. That value is added to the value of the tangible assets and any non-operating assets, and the total is the value estimate for the business as a whole. See Clean surplus accounting, Residual income valuation.
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of the business in question.
Aswath Damodaran (N.D.). Beyond Inputs: Choosing the right model
In the below cases, however, more specific valuation-practices have developed
within the investment industry. To these, more than elsewhere, real options valuation may be applied; Aswath Damodaran. Option Pricing Applications in Valuation see .
Preliminary to the valuation, the financial statements are initially recast, to "better reflect the firm's indebtedness, financing costs and recurring earnings".George Batta, Ananda Ganguly, Joshua Rosett (2012). Financial statement recasting and credit risk assessment , Accounting and Finance. Volume54, Issue1. Here adjustments are made to working capital, deferred capital expenditures, cost of goods sold, non-recurring professional fees and costs, above- or below-market leases, excess salaries in the case of private company, and certain non-operating income/expense items.Joseph Swanson and Peter Marshall, Houlihan Lokey and Lyndon Norley, Kirkland & Ellis International LLP (2008). A Practitioner's Guide to Restructuring, Andrew Miller's Valuation of a Distressed Company p. 24.
The valuation is built on this base, with any of the standard market-, income-, or asset-based approaches employed. Often these are used in combination, providing a "triangulation" or (weighted) average. Particularly in the second case above, the company may be valued using real options analysis, serving to complement (or sometimes replace) this standard value; see and Merton model.
As required, various adjustments are then made to this result, so as to reflect characteristics of the firm external to its profitability and cash flow. These adjustments consider any Marketability resulting in a discount, and re the stake in question, any control premium or lack of control discount. Balance sheet items external to the valuation, but due to the new owners, are similarly recognized; these include excess (or restricted) cash, and other non-operating assets and liabilities.
The valuation of early-stage startups “Valuing and Pricing Young and Start-Up Firms”. Ch 10 in The Corporate Life Cycle: Business, Investment, and Management Implications. Portfolio. Aswath Damodaran, 2024. can be more nuanced due to their lack of established track records. One common approach is using comparative valuations, although this method can be less accurate given the uniqueness of each startup. Some methods adjust the average pre-money valuation of pre-revenue startups based on various attributes within the same market. Average pre-money valuations in a particular region or sector, obtained from recent market deals, can also serve as reference points. During Series A funding rounds, the typical valuation for startups is reported to be between $10 million to $15 million.
Valuations here are often necessary both for financial reporting and intellectual property transactions. They are also inherent in securities analysis - listed and private equity - in cases where analysts must estimate the incremental contribution of patents (etc) to equity value; see next paragraph. Since few sales of benchmark intangible assets can ever be observed, one often values these sorts of assets using either a present value model, or by estimating the cost of recreating the asset in question. In some cases, Aswath Damodaran (N.D.), A decision tree valuation of a pharmaceutical company with one drug in the FDA pipeline Kellogg, D., & Charnes, J. M. (2000). Real-Options Valuation for a Biotechnology Company. Financial Analysts Journal, 56(3), 76–84. option-based techniques or may be applied. Regardless of the method, the process is often time-consuming and costly. If required, stock markets can give an indirect estimate of a corporation's intangible asset value: this can be reckoned as the difference between its market capitalisation and its book value (including only hard assets), i.e. effectively its goodwill; see also PVGO.
As regards listed equity, the above techniques are most often applied in the biotech-, life sciences- and pharmaceutical sectors T. Segal (2020). Biotech vs. Pharmaceuticals , investopedia.com Aswath Damodaran (N.D.), Valuation and price in the drug business Brian DeChesare (N.D.), Biotech Equity Research (see List of largest biotechnology and pharmaceutical companies). These businesses are involved in research and development (R&D), and testing, that typically takes years to complete, and where the new product may ultimately not be approved (see Contingent value rights). Industry specialists thus apply the above techniques - and here especially rNPV - to the pipeline of products under development, and, at the same time,Aswath Damodaran (N.D.). The Value of Intangibles also estimate the impact on existing revenue streams due to expiring patents. For relative valuation, a specialized ratio is R&D spend as a percentage of sales. Similar analysis may be applied to options on films re the valuation of film studios.
CIMVal generally applied by the Toronto Stock Exchange, is widely recognized as a "standard" for the valuation of mining projects. (CIMVal: Canadian Institute of Mining, Metallurgy and Petroleum on Valuation of Mineral Properties ) The Australasian equivalent is VALMIN; the Southern African is SAMVAL. These standards 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; see E.V. Lilford and R.C.A. Minnitt (2005). A comparative study of valuation methodologies for mineral developments , The Journal of The South African Institute of Mining and Metallurgy, Jan. 2005 for further discussion and context. Real Options analysis Shafiee, S and Abbate, N. (2012). Now, this is the Time for Mining Companies to Choose - Real Option Valuation or Discount Cash Flow. Australasian Institute of Mining and Metallurgy Rudolf Zdravlje (2011). Real Options Analysis of Mining Projects is sometimes used when there is a need to evaluate the project under different scenarios from inception.
Analyzing listed mining corporates (and other resource companies) is also specialized, as the valuation requires a good understanding of the company's overall assets, its operational business model as well as key market drivers, and an understanding of that sector of the stock market. Re the latter, a distinction is usually made based on size and financial capabilities; see .
The approach taken for a DCF valuation, is to then "remove" debt from the valuation, by discounting at the cost of equity either free cash flow to equity (here, net income less any reinvestment in regulatory capital) or excess return;See e.g. eqexret.xls by Prof. Aswath Damodaran a dividend based valuation is often employed. This is in contrast to the more typical approach of discounting free cash flow to the Firm where EBITDA less capital expenditures and working capital is discounted at the weighted average cost of capital, which incorporates the cost of debt.
For a multiple based valuation, similarly, PE ratio is preferred to EV/EBITDA. Here, there are also industry-specific measures used to compare between investments and within sub-sectors; this, once normalized by market cap (or other appropriate result), and recognizing regulatory differences:
Mismarking misleads investors and fund executives about how much the securities in a securities portfolio managed by a trader are worth (the securities' net asset value, or NAV), and thus misrepresents performance.Kent Oz (2009). "Independent Fund Administrators As A Solution for Hedge Fund Fraud," Fordham Journal of Corporate & Financial Law.
When a rogue trader engages in mismarking, it allows him to obtain a higher Bonus payment from the financial firm for which he works, where his bonus is calculated by the performance of the securities portfolio that he is managing.
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