What Is Valuation?

Valuation is the analytical process of determining the current (or projected) worth of an asset or a company.聽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聽market value of its assets, among other metrics.

Fundamental analysis is often employed in valuation, although several other methods may be employed such as the capital asset pricing model (CAPM) or the dividend discount model (DDM).

Key Takeaways

  • Valuation is a quantitative process of determining the fair value of an asset or a firm.
  • In general, a company can be valued on its own on an absolute basis, or else on a relative basis compared to other similar companies or assets.
  • There are several methods and techniques for arriving at a valuation鈥攅ach of which may produce a different value.
  • Valuations can be quickly impacted by corporate earnings or economic events that force analysts to retool their valuation models.
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Valuation Models: Apple鈥檚 Stock Analysis With CAPM

What Does Valuation Tell You?

A valuation can be useful when trying to聽determine the聽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 overvalued or undervalued by the market.

The Two Main Categories of Valuation Methods

Absolute valuation聽models聽attempt to find the intrinsic or "true" value of an investment based only on fundamentals. Looking at fundamentals simply means you would only focus on such things as dividends, cash flow, and the growth rate for a single company, and not worry about any other companies. Valuation models that fall into this category include the dividend discount model, discounted cash flow model,聽residual income聽model, and asset-based model.

Relative valuation聽models,聽in contrast, operate by comparing the company in question to other similar companies. These methods involve calculating multiples and聽ratios, such as the price-to-earnings multiple, and comparing them to the multiples of similar companies.

For example, if the P/E of a聽company聽is lower than the P/E multiple of a comparable company, the聽original company might be considered聽undervalued. Typically, the relative valuation model聽is a lot easier and quicker to calculate聽than the absolute聽valuation聽model, which is why many investors and analysts begin聽their analysis with this model.

How Earnings Affect Valuation

The earnings per share聽(EPS)聽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,聽valuation. Other multiples, such as EV/EBITDA, are compared with similar companies and historical multiples to calculate intrinsic聽value.

Valuation Methods

There are various ways to 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聽methods include looking at past and similar transactions of company or asset purchases, or聽comparing a company聽with聽similar businesses and their valuations.聽

The comparable company analysis聽is a method that聽looks at similar companies, in size and industry,聽and how they trade to determine a fair value for a company聽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, 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.

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聽(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.

Limitations of Valuation

When deciding which聽valuation聽method to use to value a stock for the first time, it's easy to become overwhelmed聽by the number of valuation techniques available to investors. There are valuation methods that are fairly straightforward while聽others are more involved and complicated.

Unfortunately, there's聽no one method that's聽best suited for every situation. Each stock is different, and each industry or sector has unique characteristics that may require multiple聽valuation methods. At the same time, different valuation methods will produce different values for the same underlying asset or company which may lead analysts to employ the technique that provides the most favorable output.