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Infinance,valuation is the process of determining thevalue of a (potential) investment, asset, or security. Generally, there are three approaches taken, namely discounted cashflow valuation, relative valuation, and contingent claim valuation.[1]
Valuations can be done forassets (for example, investments in marketable securities such as companies'shares and related rights,business enterprises, orintangible assets such aspatents,data andtrademarks) or forliabilities (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 asinvestment analysis,capital budgeting,merger andacquisition transactions,financial reporting, taxable events to determine the propertax liability.In abusiness valuation context, various techniques are used to determine the (hypothetical) price that a third party would pay for a given company;while in aportfolio management context,stock valuation is used byanalysts to determine theprice at which the stock is fairly valued relative to its projected and historical earnings, and to thus profit from related price movement.
Common terms for the value of an asset or liability aremarket value,fair value, andintrinsic 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. TheInternational 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:[2]
In finance, valuation analysis is required for many reasons including tax assessment,wills andestates,divorcesettlements, business analysis, and basicbookkeeping andaccounting. 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 bemark-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 includinginvestment 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 and this generatesvaluation risk. For example, options are generally valued using theBlack–Scholes model while the liabilities oflife assurance firms are valued using the theory ofpresent value. Intangible business assets, likegoodwill andintellectual property, are open to a wide range of value interpretations. Another intangible asset,data, is increasingly being recognized as a valuable asset in the information economy.[3]
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 andpresent value calculations, and analyses of bonds that focus on credit ratings, assessments ofdefault risk,risk premia, and levels ofreal 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 amerger or acquisition the respective businesses make available further detailed financial information, usually on the completion of anon-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.
Businesses or fractional interests in businesses may be valued for various purposes such asmergers and acquisitions, sale ofsecurities, and taxable events. When correct, a valuation should reflect the capacity of the business to match a certain market demand, as it is the only true predictor of future cash flows. An accurate valuation ofprivately owned companies largely depends on the reliability of the firm's historic financial information.Public companyfinancial statements are audited byCertified Public Accountants (USA),Chartered Certified Accountants (ACCA) orChartered Accountants (UK), andChartered 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 performsdue diligence to verify the seller's information.
Financial statements prepared in accordance withgenerally accepted accounting principles (GAAP) show many assets based on their historic costs rather than at their current market values. For instance, a firm'sbalance 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 theCBV Institute, ASA and CEIV from theAmerican Society of Appraisers, and the CVA by the National Association of Certified Valuators and Analysts.
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 thetime 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 anopportunity cost of capital and it is expressed as a percentage ordiscount rate.
In finance theory, the amount of theopportunity 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 avaluation using thediscounted 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 thecapital markets. Next, one makes a calculation to compute the present value of the future cash flows.
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 calculatesprice multiples such as theprice-to-earnings orprice-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.
The third-most common method of estimating the value of a company looks to theassets andliabilities of the business. At a minimum, asolvent company could shut down operations, sell off the assets, and pay thecreditors. Any cash that would remain establishes a floor value for the company. This method is known as thenet asset value or cost method. In general thediscounted 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 asnonprofits, for which discounted cash flow analysis is not relevant. The valuation premise normally used is that of an orderlyliquidation of the assets, although some valuation scenarios (e.g.,purchase price allocation) imply an "in-use" valuation such asdepreciated replacement cost new.This method is most appropriate in situations where there are no significant intangible assets, or when a company is voluntarily liquidating its assets as a result of ceased operations.
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'sAppeals and Review Memorandum 34,[further explanation needed] and later refined byRevenue Ruling 68-609Archived 2020-05-23 at theWayback Machine.) 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. SeeClean surplus accounting,Residual income valuation.
The approaches to valuation outlined above, are generic and will be modified for the unique positioning and characteristics[4]of the business in question.[5]In the following cases, however, more specific valuation-practiceshave developed[6] within theinvestment industry.To these, more than elsewhere,real options valuation may be applied;[7]seeBusiness valuation § Option pricing approaches.
Investors in asuffering company, or in other "distressed securities", may intend (i) torestructure the business, with the valuationreflecting its potential thereafter, or (ii) to purchase the company - or its debt - at a discount,as part of an Investment Strategy aimed atrealizing a profit on recovery.
Preliminary to the valuation, thefinancial statements areinitially recast, to "better reflect the firm's indebtedness, financing costs and recurring earnings".[8] Here adjustments are made toworking capital, deferredcapital expenditures,cost of goods sold, non-recurring professional fees and costs, above- or below-market leases, excess salaries in the case ofprivate companies, and certain non-operating income/expense items.[9]
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 usingreal options analysis, serving to complement (or sometimes replace) this standard value; seeBusiness valuation § Option pricing approaches andMerton 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 anylack of marketability resulting in a discount, and re the stake in question, anycontrol premium orlack 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.
Startup companies such asUber, which was valued at $50 billion in early 2015, are assignedpost-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 partventure 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.[10] 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, seeDot-com bubble.[11]Valuation using discounted cash flows discusses various considerations here.
The valuation of early-stage startups[12]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.[13] Some methods adjust the averagepre-money valuation of pre-revenue startups based on various attributes within the same market.[14] Average pre-money valuations in a particular region or sector, obtained from recent market deals, can also serve as reference points.[15] DuringSeries A funding rounds, the typical valuation for startups is reported to be between $10 million to $15 million.[16]
Valuation models can be used to valueintangible assets such as forpatent valuation, but also incopyrights,software,trade secrets, and customer relationships.[17]As economies are becoming increasingly informational, it is recognized that there is a need for new methods tovalue data, another intangible asset.
Valuations here are often necessary both forfinancial reporting andintellectual property transactions.They are also inherent insecurities analysis - listed andprivate - in cases whereanalysts must estimate theincremental 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 byestimating the cost of recreating the asset in question. In some cases,[18][19]option-based techniques ordecision trees may be applied.If required, stock markets can give an indirect estimate of a corporation's intangible asset value: this can be reckoned as the difference between itsmarket capitalisation and itsbook value (includingonly hard assets), i.e. effectively itsgoodwill; see alsoPVGO.Regardless of the method, the process is often time-consuming and costly.
As regards listed equity, the above techniques are most often applied in thebiotech-,life sciences- andpharmaceutical sectors[20][21][22][19](seeList of largest biotechnology and pharmaceutical companies).These businesses are involved inresearch and development (R&D), and testing, that typically takes years to complete, and where the new product may ultimatelynot be approved[19] (seeContingent value rights).Industry specialists thus apply the above techniques - and here especiallyrNPV - to thepipeline of products under development, and, at the same time,[17] also estimate the impact on existing revenue streams due toexpiring patents. For relative valuation,[20] a specialized ratio is R&D spend as a percentage of sales. Similar analysis may be applied tooptions on films re the valuation offilm studios.
Inmining, valuation is the process of determining the value or worth of amining property - i.e. as distinct from a listed mining corporate. Mining valuations are sometimes required forIPOs,fairness opinions, litigation, mergers and acquisitions, and shareholder-related matters. In valuing a mining project or mining property,fair market value is the standard of value to be used.In general,[23]this result will be a function of the property's"reserve" - the estimated size and grade of thedeposit in question - andthe complexity and costs of extracting this.[24][25]
CIMVal[26][27] generally applied by theToronto 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[28])TheAustralasian equivalent isVALMIN; theSouthern African isSAMVAL.These standards stress the use of thecost approach,market approach, and theincome approach, depending on the stage of development of the mining property or project; see[29] for further discussion and context.Real Options analysis[30][31] is sometimes[23][29][30] used when there is a need to evaluate the projectunder different scenarios from inception.
Analyzing listedmining corporates (and otherresource companies) is also specialized,[24]as the valuation requires agood understanding of the company's overall assets, its operational business modelas well as key market drivers,[32]and an understanding of thatsector of the stock market.[24]Re the latter, a distinction is usually made based on size and financial capabilities; seeMining § Corporate classifications.
There are two main difficulties with valuingfinancial services firms.[33][34][35][36][37]The first is that the cash flows to a financial service firm cannot be easily estimated, sincecapital 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 ofcost of capital andenterprise value may be meaningless as a consequence."[33](Seerelated discussion re. therisk management of financial- vs non-financial firms.)The second is that these firms operate under ahighly regulated environment, and valuation assumptions (and model outputs) must incorporate regulatory limits, at least as "bounds".[36]
The approach taken for a DCF valuation, is to then "remove" debt from the valuation, by discounting at thecost of equity eitherfree cash flow to equity (here,net income less any reinvestment inregulatory capital) orexcess return;[38] adividend based valuation is often employed. This is in contrast to the more typical approach ofdiscounting free cash flow to theFirm whereEBITDA less capital expenditures and working capital is discounted at theweighted average cost of capital, which incorporates thecost of debt.
For a multiple based valuation, similarly,price to earnings is preferred toEV/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 in securities valuation takes place when the value that is assigned to securities does not reflect what the securities are actually worth, due to intentionalfraudulent mispricing.[39][40][41]
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.[42][43][44]
When arogue trader engages in mismarking, it allows him to obtain a higherbonus from the financial firm for which he works, where his bonus is calculated by the performance of the securities portfolio that he is managing.[42][43]
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.
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