- Valuation refers to the process of determining the true value of an asset
- Valuation plays an important role when a company is being bought, sold or merged
- Valuation of an asset is done by the investors to typically take either long or short position in the asset.
What is Valuation?
Valuation refers to the process of determining the true value of an asset, either through rigorous analysis of the key drivers which determines its value or using a comparable asset to determine its value.
Significance of Valuation
When one tries to find the fair value of an asset or a security, Valuation usually proves to be very useful. Analyst use valuation to know whether an asset or a company is undervalued or overvalued by the market. Market value of bonds and stocks are determined by buyers and sellers of the security. In reference to a company, valuation plays an important role when it is being bought, sold or merged. Valuation is also necessary when a company is planning to raise funds.
Valuation of an asset is also done by the investors to typically take either a long or short position in the asset. If the valuation shows that the true value of the asset is more than its current market price, then the investor would go long or buy the asset and if the true value of the asset is less than the market value then the investor would go short or sell the asset.
Methods of Valuation
It is to be noted that valuation involves a lot of assumptions by the person doing the valuation and such assumptions are subjective, so there can be different values perceived by different evaluators. Some of the methods to do valuation are:
1. Absolute Valuation
Absolute Valuation models using various fundamental parameters to determine the value of a company. This model is not concerned with other companies in the same industry and calculates cash flows, dividends, growth rates, etc. of a single company.
2. Relative Valuation
Relative valuation compares various ratios and parameters of the company in question with that of its parameters to arrive at a more holistic result.
3. Discounted Cash Flow Valuation
This method calculates the value of an asset by discounting its future cash flows with a discounting rate. For example, if a company decides to buy machinery, it may discount all the cash inflows and cash outflows with a discount rate to arrive at a net present value.
4. Future Earnings Valuation
It is believed that future gains and cash inflows of a company affects its value today. In this method, sales figures, gross profits and expenses of the past few years are analysed to gauge the future and determine the value of a company today.
Limitations of Valuation
When one decides to do valuation of an asset or a company, there are a number of methods available to do that. But not every method fits for every situation. Different businesses in different industries have unique characteristics. So, one may have to use multiple valuation methods. But there is a decent chance that different valuation methods will lead to different results for the same asset. Analysts have to find out the best method to deploy which results in most accurate output.