Valuation refers to the process of determining the present value of a company, investment or an asset. It can be done using a number of methods, as described below. Analysts who want to place a value on an asset normally look at the prospective future earning potential of that company or asset.
By trading a security on an exchange, sellers and buyers will dictate the market value of that bond or stock. However, intrinsic value is a concept that refers to a security’s perceived value on the basis of future earnings or other attributes that are not related to a security’s market value. Therefore, the work of analysts when doing valuation is to know if an investment or a company is undervalued or overvalued by the market.
Valuation is the process of determining the theoretically correct value of a company, investment or asset, as opposed to its cost or current market value.
Common reasons for performing a valuation are for M&A, strategic planning, capital financing and investing in securities.
The three most common valuation methods are: DCF analysis, comparable company analysis and precedent transactions.
Reasons for performing a valuation
Valuation is an important exercise since it can help identify mispriced securities or determine what projects a company should invest. Some of the main reasons for performing a valuation are listed below.
1. Buying or selling a business
Buyers and sellers will normally have a difference in the value of a business. Both parties would benefit from a valuation when making their ultimate decision on whether to buy or sell and at what price.
2. Strategic planning
A company should only invest in projects that increase itsnet present value. Therefore, any investment decision is essentially a mini-valuation based on the likelihood of future profitability and value creation.
3. Capital financing
An objective valuation may be useful when negotiating with banks or any other potential investors for funding. Documentation of a company’s worth, and its ability to generate cash flow, enhances credibility to lenders and equity investors.
4. Securities investing
Investing in a security, such as a stock or a bond, is essentially a bet that the current market price of the security is not reflective of its intrinsic value. A valuation is necessary in determining that intrinsic value.
What are the main valuation methods?
When valuing a company as a going concern, there are three main valuation methods used by industry practitioners: (1) DCF analysis, (2) comparable company analysis, and (3) precedent transactions. These are the most common methods of valuation used in investment banking, equity research, private equity, corporate development, mergers & acquisitions (M&A), leveraged buyouts (LBO), and most areas of finance.
As shown in the diagram above, when valuing a business or asset, there are three different approaches one can use. The Asset Approach calculates the fair market value of individual assets, often including the cost to build or cost to replace. The Asset Approach method is useful in valuing real estate, such as commercial property, new construction, or special-use properties.
Next is the Income Approach, with the discounted cash flow (DCF) being the most common. A DCF is the most detailed and thorough approach to valuation modeling.
The final approach is the Market Approach, which is a form of relative valuation and is frequently used in the finance industry. It includes Comparable Company Analysis and Precedent Transactions Analysis. We will describe the methods used in the DCF and Market approaches below.
A DCF analysis is performed by building a financial model in Excel and requires an extensive amount of detail and analysis. It is the most detailed of the three approaches and requires the most estimates and assumptions. Therefore, the effort required to preparing a DCF model may also often result in the least accurate valuation due to the sheer number of inputs. However, a DCF model allows the analyst to forecast value based on different scenarios and even perform a sensitivity analysis.
For larger businesses, the DCF value is commonly a sum-of-the-parts analysis, where different business units are modeled individually and added together. To learn more, see CFI’s DCF model infographic.
The “comps” valuation method provides an observable value for the business, based on what other comparable companies are currently worth. Comps is the most widely used approach, as the multiples are easy to calculate and always current. The logic follows that if company X trades at a 10-times P/E ratio, and company Y has earnings of $2.50 per share, company Y’s stock must be worth $25.00 per share (assuming the companies have similar risk and return characteristics).
Method 3: Precedent Transactions
Precedent transactions analysis is another form of relative valuation where you compare the company in question to other businesses that have recently been sold or acquired in the same industry. These transaction values include the take-over premium included in the price for which they were acquired.
The values represent the entire value of a business and not just a small stake. They are useful for M&A transactions but can easily become dated and no longer reflective of current market conditions as time passes.
Football Field Chart (summary)
Investment bankers will often put together a football field chart to summarize the range of values for a business based on the different valuation methods used. Below is an example of a football field graph, which is typically included in an investment banking pitch book.
As you can see, the graph summarizes the company’s 52-week trading range (it’s stock price, assuming it’s public), the range of prices equity research analysts have for the stock, the range of values from comparable valuation modeling, the range from precedent transaction analysis, and finally the DCF valuation method. The orange dotted line in the middle represents the average valuation from all the methods.
More Valuation Methods
Another valuation method for a company that is a going concern is called the ability-to-pay analysis. This approach looks at the maximum price an acquirer can pay for a business while still hitting some target. For example, if a private equity firm needs to hit a hurdle rate of 30%, what is the maximum price it can pay for the business?
If the company does not continue to operate, then a liquidation value will be estimated based on breaking up and selling the company’s assets. This value is usually very discounted as it assumes the assets will be sold as quickly as possible to any buyer.