Valuation is the process of determining the current worth of an asset or a company. There are many techniques used for doing a valuation. An analyst placing a value on a company looks at the business’s management, the composition of its capital structure, the prospect of future earnings, and the market value of its assets.
A valuation can be useful when trying to determine the fair value of a security, which is determined by what a buyer is willing to pay a seller, assuming both parties enter the transaction willingly. When a security trades on an exchange, buyers and sellers determine the market value of a stock or bond. The concept of intrinsic value, however, refers to the perceived value of a security based on future earnings or some other company attribute unrelated to the market price of a security. That’s where valuation comes into play. Analysts do a valuation to determine whether a company or asset is over- or undervalued by the market.
How earnings affect Valuation
The earnings per share (EPS) formula is stated as earnings available to common shareholders divided by the number of common stock shares outstanding. EPS is an indicator of company profit because the more earnings a company can generate per share, the more valuable each share is to investors. Analysts also use the price-to-earnings (P/E) ratio for stock valuation, which is calculated as market price per share divided by EPS. The P/E ratio calculates how expensive a stock price is relative to the earnings produced per share.
For example, if the P/E ratio of a stock is 20 times earnings, an analyst compares that P/E ratio with other companies in the same industry and with the ratio for the broader market. In equity analysis, using ratios like the P/E to value a company is called a multiples-based, or multiples approach, valuation. Other multiples, such as EV/EBITDA, are compared with similar companies and historical multiples to calculate intrinsic value.
Discounted cash flow Valuation
Analysts also place a value on an asset or investment using the cash inflows and outflows generated by the asset, called a discounted cash flow (DCF) analysis. These cash flows are discounted into a current value using a discount rate, which is an assumption about interest rates or a minimum rate of return assumed by the investor. If a company is buying a piece of machinery, the firm analyzes the cash outflow for the purchase and the additional cash inflows generated by the new asset. All the cash flows are discounted to a present value, and the business determines the net present value (NPV). If the NPV is a positive number, the company should make the investment and buy the asset.
There are various ways do a valuation. The discounted cash flow analysis mentioned above is one method, which calculates the value of a business or asset based on its earnings potential. Other methods include looking at past and similar transactions of company or asset purchases, or comparing a company with similar businesses and their valuations.
The comparable company analysis is a method that looks at similar companies, in size and industry, and how they trade to determine a fair value for a company or asset. The past transaction method looks at past transactions of similar companies to determine an appropriate value. There’s also the asset-based valuation method, which adds up all the company’s asset values, assuming they were sold at fair market value, and to get the intrinsic value. Sometimes doing all of these and then weighing each is appropriate to calculate intrinsic value. Meanwhile, some methods are more appropriate for certain industries and not others. For example, you wouldn’t use an asset-based valuation approach to valuing a consulting company that has few assets; instead, an earnings-based approach like the DCF would be more appropriate.