Valuation

Valuation — What it Is and How it Works

Valuation is the process of estimating the fair or intrinsic value of an asset, business, or security. It helps determine whether something is overvalued or undervalued relative to its market price, and informs decisions like investing, buying or selling a company, raising capital, divestitures, and estate planning.

Key concepts
* Market value — the price at which a security trades in the market, set by buyers and sellers.
* Intrinsic value — the analyst’s estimate of true value based on fundamentals such as cash flows, earnings potential, or asset values.
* Valuation involves both quantitative models and subjective assumptions (growth rates, discount rates, comparable companies).

Main Approaches to Valuation

Valuation methods generally fall into two broad categories:

Absolute valuation
* Seeks an intrinsic value based only on the company’s fundamentals.
* Common models: Discounted Cash Flow (DCF), Dividend Discount Model (DDM), residual income, and asset-based valuation.
* Strength: focuses on the company’s own cash-generation capacity.
* Sensitivity: highly sensitive to forecasted cash flows and chosen discount rate.

Relative valuation
* Compares the target company to similar companies using multiples and ratios.
* Typical multiples: Price/Earnings (P/E), EV/EBITDA, Price/Book (P/B).
* Strength: quick and market-referenced.
* Limitation: depends on finding truly comparable firms and can reflect market-wide mispricing.

Common Valuation Methods

Comparables (Comparable Company Analysis)
* Uses trading multiples from peer companies to estimate a fair value.
* Widely used for quick checks and screen-level analysis.

Precedent Transactions
* Compares recent acquisition prices of similar companies to estimate what buyers paid in the market.
* Common in M&A because it reflects transaction premiums and market conditions.

Discounted Cash Flow (DCF)
* Projects future cash flows and discounts them to present value using a discount rate (cost of capital).
* Produces Net Present Value (NPV); a positive NPV suggests the investment adds value.
* Often used with dividend discount variants like the Gordon Growth Model for dividend-paying firms.

Asset-Based Valuation
* Values the company by summing the fair market value of its assets and subtracting liabilities.
* More appropriate for asset-heavy or liquidation scenarios; less so for service or IP-heavy firms.

Other models and tools
* Capital Asset Pricing Model (CAPM) — often used to estimate the discount rate (cost of equity).
* Residual income models, liquidation value, and industry-specific approaches for startups or private firms.

How Earnings and Multiples Affect Valuation

Earnings metrics feed many valuation approaches:
* Earnings per Share (EPS) = Net earnings available to common shareholders ÷ Shares outstanding. Higher EPS generally supports higher per-share value.
* Price-to-Earnings (P/E) = Market price per share ÷ EPS. Comparing a stock’s P/E to peers and historical averages helps assess relative expensiveness.
* Enterprise Value (EV) multiples such as EV/EBITDA compare enterprise value to operating profit measures and are useful for capital-structure-neutral comparisons.

Multiples-based valuation is quick but depends on meaningful comparables and consistent accounting.

Limitations and Risks

• No single method fits all situations. Industry, company maturity, and capital structure influence the best approach.
• Results differ by method and by assumptions (growth rates, margins, discount rates). Analysts may unconsciously favor inputs that support a preferred outcome.
• Market events and earnings announcements can rapidly alter valuation inputs and conclusions.
• Private or early-stage companies are harder to value due to limited data and higher uncertainty.

Simple Examples

Market capitalization (quick market-based example)
* Market cap = Share price × Shares outstanding.
* Example: $10 share price × 2,000,000 shares = $20,000,000 market cap.

Basic DCF concept
* Project cash flows for future years, discount each by (1 + discount rate)^n, sum present values = intrinsic value.

Asset-based example
* Total fair-value assets − total liabilities = equity value.

When and Why Valuation Is Used

Valuation answers “what is this worth?” and supports:
* Investment decisions (buy, hold, sell)
* Mergers & acquisitions and deal negotiations
* Raising capital or setting prices for equity issuance
* Corporate restructuring, spin-offs, and divestitures
* Estate planning and litigation

Bottom Line

Valuation combines financial analysis, judgment, and market context to estimate value. Choose methods suited to the business and purpose (e.g., DCF for cash-generative firms, comparables for quick market checks, transaction analysis for M&A). Always test sensitivity to key assumptions and consider multiple methods to form a balanced view.