Valuation (finance)

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 v
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In finance, valuation is the process of determining the present value (PV) of

an asset. 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 needed for many reasons such as investment analysis, capital
budgeting, merger and acquisition transactions, financial reporting, taxable events to
determine the proper tax liability.

Contents

 1Valuation overview
 2Usage
 3Business valuation
o 3.1Discounted cash flow method
o 3.2Guideline companies method
o 3.3Net asset value method
 4Specialised cases
o 4.1Valuation of a suffering company
o 4.2Valuation of a startup company
o 4.3Valuation of intangible assets
o 4.4Valuation of mining projects
o 4.5Valuing financial service firms
 5See also
 6References

Valuation overview[edit]
Common terms for the value of an asset or liability are market value, fair value,
and intrinsic value. The meanings of these terms differ. For instance, when an
analyst believes a stock's intrinsic value is greater (or less) than its market price, an
analyst makes a "buy" (or "sell") recommendation. Moreover, an asset's intrinsic
value may be subject to personal opinion and vary among analysts. The International
Valuation Standards include definitions for common bases of value and generally
accepted practice procedures for valuing assets of all types. Regardless, the
valuation itself is done generally using one or more of the following approaches; [1] but
see also, Outline of finance #Valuation:

1. Absolute value models ("Intrinsic valuation") that

determine the present value of an asset's expected
future cash flows. These models take two general
forms: multi-period models such as discounted cash
flow models, or single-period models such as
the Gordon model (which, in fact,
often "telescope" the former). These models rely on
mathematics rather than price observation.
See #Discounted cash flow valuation.
 2. Relative value models determine value based on the
observation of market prices of 'comparable' assets,
relative to a common variable like earnings,
cashflows, book value or sales. This result will often
be used to complement / assess the intrinsic
valuation. See #Relative valuation.
3. Option pricing models, in this context, are used to
value specific balance-sheet items, or the asset
itself, when these have option-like characteristics.
Examples of the first type are warrants, employee
stock options, and investments with embedded
options such as callable bonds; the second type are
usually real options. The most common option
pricing models employed here are the Black–
Scholes-Merton models and lattice models. This
approach is sometimes referred to as contingent
claim valuation, in that the value will be contingent
on some other asset; see #Contingent claim
valuation.

Usage[edit]
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 like 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-cash-flow 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 important to note that valuation requires judgment and assumptions:

 There are different circumstances and purposes to

value an asset (e.g., distressed firm, tax purposes,
mergers and acquisitions, financial reporting). Such
differences can lead to different valuation methods or
different interpretations of the method results
 All valuation models and methods have limitations (e.g.,
degree of complexity, relevance of observations,
mathematical form)
 Model inputs can vary significantly because of
necessary judgment and differing 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.

Business valuation[edit]
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 firm's historic financial information. Public company financial statements are
audited by Certified Public Accountants (USA), Chartered Certified
Accountants (ACCA) or Chartered Accountants (UK), and Chartered Professional
Accountants (Canada) and overseen by a government regulator. Alternatively,
private firms do not have government oversight—unless operating in a regulated
industry—and are usually not required to have their financial statements audited.
Moreover, managers of private firms often prepare their financial statements to
minimize profits and, therefore, taxes. Alternatively, managers of public firms tend to
want higher profits to increase their stock price. Therefore, a firm's historic financial
information may not be accurate and can lead to over- and undervaluation. In an
acquisition, a buyer often performs due diligence to verify the seller's information.
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.
Discounted cash flow method[edit]
Main article: Valuation using discounted cash flows
This method estimates the value of an asset based on its expected future cash
flows, which are discounted to the present (i.e., the present value). This concept of
discounting future money is commonly known as the time value of money. For
instance, an asset that matures and pays $1 in one year is worth less than $1 today.
The size of the discount is based on an opportunity cost of capital and it is expressed
as a percentage or discount rate.
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.
Guideline companies method[edit]
Main article: Comparable company analysis
This method determines the value of a firm by observing the prices of similar
companies (called "guideline companies") that sold in the market. Those sales could
be shares of stock or sales of entire firms. The observed prices serve as valuation
benchmarks. From the prices, one calculates price multiples such as the price-to-
earnings or price-to-book ratios—one or more of which used to value the firm. For
example, the average price-to-earnings multiple of the guideline companies is
applied to the subject firm's earnings to estimate its value.
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.
Net asset value method[edit]
The third-most common method of estimating the value of a company looks to
the assets and liabilities of the business. At a minimum, a solvent company could
shut down operations, sell off the assets, and pay the creditors. Any cash that would
remain establishes a floor value for the company. This method is known as the net
asset value or cost method. In general the discounted cash flows of a well-
performing company exceed this floor value. Some companies, however, are worth
more "dead than alive", like weakly performing companies that own many tangible
assets. This method can also be used to value heterogeneous portfolios of
investments, as well as nonprofits, for which discounted cash flow analysis is not
relevant. The valuation premise normally used is that of an orderly liquidation of the
assets, although some valuation scenarios (e.g., purchase price allocation) imply an
"in-use" valuation such as depreciated replacement cost new.
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,[further explanation needed] 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.

Specialised cases[edit]
In the below cases, depending on context, Real options valuation techniques are
also sometimes employed, if not preferred; for further discussion here see Business
valuation#Option pricing approaches, Corporate finance#Valuing flexibility.
Valuation of a suffering company[edit]
When valuing "distressed securities", various adjustments are typically made to the
valuation result; this would be true whether market-, income-, or asset-based. These
adjustments consider:

 Lack of marketability discount of shares

 Control premium or lack of control discount
 Excess or restricted cash
 Other non-operating assets and liabilities
 Above- or below-market leases
 Excess salaries in the case of private companies
The financial statements here are similarly recast, including adjustments to working
capital, deferred capital expenditures, cost of goods sold, non-recurring professional
fees and costs, and certain non-operating income/expense items. [2]
In many of these cases, the company in question is valued using real options
analysis - see Business valuation#Option pricing approaches. This value serves to
complement (or sometimes replace) the above value.
Valuation of a startup company[edit]
Startup companies such as Uber, which was valued at $50 billion in early 2015, are
assigned post-money valuations based on the price at which their most recent
investor put money into the company. The price reflects what investors, for the most
part venture capital firms, are willing to pay for a share of the firm. They are not listed
on any stock market, nor is the valuation based on their assets or profits, but on their
potential for success, growth, and eventually, possible profits. [3] Many startup
companies use internal growth factors to show their potential growth which may
attribute to their valuation. The professional investors who fund startups are experts,
but hardly infallible, see Dot-com bubble.[4] Valuation using discounted cash
flows discusses various considerations here.
Valuation of intangible assets[edit]
See: Patent valuation#Option-based method.
Valuation models can be used to value intangible assets
such as for patent valuation, but also
in copyrights, software, trade secrets, and customer
relationships. 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
estimating the costs to recreate it. Regardless of the
method, the process is often time-consuming and costly.
Valuations of intangible assets are often necessary for
financial reporting and intellectual property transactions.
Stock markets give indirectly an estimate of a
corporation's intangible asset value. It can be reckoned
as the difference between its market capitalisation and
its book value (by including only hard assets in it).
Valuation of mining projects[edit]
In mining, valuation is the process of determining the
value or worth of a mining property (i.e. as distinct from
a listed mining corporate). Mining valuations are
sometimes required for IPOs, fairness opinions,
litigation, mergers and 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.
"CIMVal" generally applied by the Toronto Stock
Exchange, is widely recognised as a "standard" for the
valuation of mining projects. (CIMVal: Canadian Institute
of Mining, Metallurgy and Petroleum on Valuation of
Mineral Properties [5]) 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 [6] for further discussion and
context, as well as Mineral economics in general,
and Mineral resource classification.
Valuing financial service firms[edit]
There are two main difficulties with valuing financial
services firms.[7][8] The first is that the cash flows to a
financial service firm cannot be easily estimated,
since capital expenditures, working capital and debt are
not clearly defined: "debt for a financial service firm is
more akin to raw material than to a source of capital; the
notion of cost of capital and enterprise value (EV) may
be meaningless as a consequence."[7] The second is that
these firms operate under a highly regulated framework,
and valuation assumptions (and model outputs) must
incorporate regulatory limits, at least as "bounds".
The approach taken for a DCF valuation, is to then
"remove" debt from the valuation, by discounting free
cash flow to equity at the cost of equity (or equivalently
to apply a modified dividend discount model). This is in
contrast to the more typical approach of discounting free
cash flow to the  Firm where EBIDTA 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, price to earnings is preferred to EV/EBITDA.

See also[edit]
 Applied information economics
 Appraisal (disambiguation)
 Asset price inflation
 Business valuation
 Business valuation standard
 Depreciation
 Earnings response coefficient
 Efficient-market hypothesis
 Equity investment
 Fundamental analysis
 Intellectual property valuation
 Investment management
 Lipper average
 Market-based valuation
 Paper valuation
 Patent valuation
 Present value
 Pricing
 Real estate appraisal
 Stock valuation
 Price discovery
 Real options valuation
 Technical analysis
 Terminal value
 Enterprise value
 Sum-of-the-parts analysis
 Minority discount
 Control premium
 Specific pricing models
o Capital asset pricing model
o Arbitrage pricing theory
o Black–Scholes (for options)
o Fuzzy pay-off method for real option valuation
o Single-index model
o Markov switching multifractal
o Multiple factor models
o Chepakovich valuation model

References[edit]
1. ^ Aswath Damodaran (2012). An Introduction to
Valuation. NYU teaching note
2. ^ 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. ISBN 978-1-
905121-31-1
3. ^ Cook, Andrew.  "Investing in Potential".  five23.io.
Retrieved 2017-03-15.
4. ^ Andrew Ross Sorkin (May 11, 2015). "Main Street
Portfolios Are Investing in Unicorns"  (Dealbook blog).  The
New York Times. Retrieved  May 12, 2015.  There is no
meaningful stock market for these shares. Their values are
based on what a small handful of investors—usually venture
capital firms, private equity firms or other corporations—are
willing to pay for a stake.
5. ^ Standards and Guidelines for Valuation of Mineral
Properties. Special committee of the Canadian Institute Of
Mining, Metallurgy and Petroleum on Valuation of Mineral
Properties (CIMVAL), February 2003.
6. ^ 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
7. ^ Jump up to:a b Aswath Damodaran (2009). Valuing Financial
Service Firms, Stern, NYU
 8. ^ Doron Nissim (2010).Analysis and Valuation of Insurance
Companies, Columbia Business School

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