Valuation (finance)

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 the time 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 an opportunity cost of capital and it is expressed as a percentage or discount rate.

In finance theory, the amount of the opportunity 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 a valuation using the discounted 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 the capital 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 calculates price multiples such as the price-to-earnings or price-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 the assets and liabilities of the business. At a minimum, a solvent company could shut down operations, sell off the assets, and pay the creditors. Any cash that would remain establishes a floor value for the company. This method is known as the net asset value or cost method. In general the discounted 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 as nonprofits, for which discounted cash flow analysis is not relevant. The valuation premise normally used is that of an orderly liquidation of the assets, although some valuation scenarios (e.g., purchase price allocation) imply an "in-use" valuation such as depreciated replacement cost new.

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's Appeals and Review Memorandum 34, and later refined by Revenue Ruling 68-609.) 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. See Clean surplus accounting, Residual Income Valuation.

When valuing "distressed securities", various adjustments are typically made to the valuation result; this would be true whether market-, income-, or asset-based. These adjustments consider:

• Lack of marketability discount of shares
• Control premium or lack of control discount
• Excess or restricted cash
• Other non-operating assets and liabilities
• Above- or below-market leases
• Excess salaries in the case of private companies

The financial statements here are similarly recast, including adjustments to working capital, deferred capital expenditures, cost of goods sold, non-recurring professional fees and costs, and certain non-operating income/expense items.[2]

In many of these cases, the company in question is valued using real options analysis - see Business valuation#Option pricing approaches. This value serves to complement (or sometimes replace) the above value.

Startup companies such as Uber, which was valued at $50 billion in early 2015, are assigned post-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 part venture 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.[3] 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, see Dot-com bubble.[4] Valuation using discounted cash flows discusses various considerations here.

See: Patent valuation#Option-based method.

Valuation models can be used to value intangible assets such as for patent valuation, but also in copyrights, software, trade secrets, and customer relationships. 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 estimating the costs to recreate it. Regardless of the method, the process is often time-consuming and costly.

Valuations of intangible assets are often necessary for financial reporting and intellectual property transactions.

Stock markets give indirectly an estimate of a corporation's intangible asset value. It can be reckoned as the difference between its market capitalisation and its book value (by including only hard assets in it).

In mining, valuation is the process of determining the value or worth of a mining property (i.e. as distinct from a listed mining corporate). Mining valuations are sometimes required for IPOs, fairness opinions, litigation, mergers and acquisitions, and shareholder-related matters. In valuation of a mining project or mining property, fair market value is the standard of value to be used.

"CIMVal" generally applied by the Toronto Stock Exchange, is widely recognised as a "standard" for the valuation of mining projects. (CIMVal: Canadian Institute of Mining, Metallurgy and Petroleum on Valuation of Mineral Properties [5]) The Australasian equivalent is VALMIN; the Southern African is SAMVAL.

These standards stress the use of the cost approach, market approach, and the income approach, depending on the stage of development of the mining property or project. See [6] for further discussion and context, as well as Mineral economics in general, and Mineral resource classification.

There are two main difficulties with valuing financial services firms.[7][8] The first is that the cash flows to a financial service firm cannot be easily estimated, since capital 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 of cost of capital and enterprise value (EV) may be meaningless as a consequence." The second is that these firms operate under a highly regulated framework, and valuation assumptions (and model outputs) must incorporate regulatory limits, at least as "bounds".

The approach taken for a DCF valuation, is to then "remove" debt from the valuation, by discounting free cash flow to equity at the cost of equity (or equivalently to apply a modified dividend discount model). This is in contrast to the more typical approach of discounting free cash flow to the Firm where EBIDTA less capital expenditures and working capital is discounted at the weighted average cost of capital, which incorporates the cost of debt. For a multiple based valuation, similarly, price to earnings is preferred to EV/EBITDA.