In
finance,
valuation is the process of estimating what something is worth.
[1] Items that are usually valued are a financial
asset or
liability. Valuations can be done on assets (for example, investments in marketable securities such as
stocks,
options,
business enterprises, or
intangible assets such as
patents and
trademarks) or on liabilities (e.g.,
bonds issued by a company). Valuations are needed for many reasons such as
investment analysis,
capital budgeting,
merger and
acquisition transactions,
financial reporting, taxable events to determine the proper
tax liability, and in
litigation.
Valuation overview
Valuation of financial assets is done using one or more of these types of models:
- Absolute value models that determine the present value of an asset's
expected future cash flows. These kinds of models take two general
forms: multi-period models such as discounted cash flow models or single-period models such as the Gordon model. These models rely on mathematics rather than price observation.
- Relative value models determine value based on the observation of market prices of similar assets.
- Option pricing models are used for certain types of financial assets (e.g., warrants, put options, call options, employee stock options, investments with embedded options such as a callable bond) and are a complex present value model. The most common option pricing models are the Black–Scholes-Merton models and lattice models.
Common terms for the value of an asset or liability are
market value,
fair value, and
intrinsic value.
The meanings of these terms differ. For instance, when an analyst
believes a stock's intrinsic value is greater (less) than its market
price, an analyst makes a "buy" ("sell") recommendation. Moreover, an
asset's intrinsic value may be subject to personal opinion and vary
among analysts.
The
International Valuation Standards include definitions for common bases of value and generally accepted practice procedures for valuing assets of all types.
Business valuation
Businesses or fractional interests in businesses may be valued for various purposes such as
mergers and acquisitions, sale of
securities, and taxable events. An accurate valuation of
privately owned companies largely depends on the reliability of the firm's historic financial information.
Public company financial statements are audited by
Certified Public Accountants (USA),
Chartered Certified Accountants (
ACCA) or
Chartered Accountants
(UK and Canada) and overseen by a government regulator. Alternatively,
private firms do not have government oversight—unless operating in a
regulated industry—and are usually not required to have their financial
statements audited. Moreover, managers of private firms often prepare
their financial statements to minimize profits and, therefore,
taxes.
Alternatively, managers of public firms tend to want higher profits to
increase their stock price. Therefore, a firm's historic financial
information may not be accurate and can lead to over- and
undervaluation. In an acquisition, a buyer often performs
due diligence to verify the seller's information.
Financial statements prepared in accordance with
generally accepted accounting principles (GAAP) show many assets based on their historic costs rather than at their current market values. For instance, a firm's
balance sheet
will usually show the value of land it owns at what the firm paid for
it rather than at its current market value. But under GAAP requirements,
a firm must show the fair values (which usually approximates market
value) of some types of assets such as financial instruments that are
held for sale rather than at their original cost. When a firm is
required to show some of its assets at fair value, some call this
process "
mark-to-market".
But reporting asset values on financial statements at fair values gives
managers ample opportunity to slant asset values upward to artificially
increase profits and their stock prices. Managers may be motivated to
alter earnings upward so they can earn bonuses. Despite the risk of
manager bias, equity investors and creditors prefer to know the market
values of a firm's assets—rather than their historical costs—because
current values give them better information to make decisions.
There are commonly three pillars to valuing business entities:
comparable company analyses, discounted cash flow analysis, and
precedent transaction analysis
Discounted Cash Flow Method
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.
Guideline companies method
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.
Net asset value method
Main article:
Cost method
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 ARM34, and later
refined by the U.S.
Internal Revenue Service's
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.
Usage
In finance, valuation analysis is required for many reasons including tax assessment,
wills and
estates,
divorce settlements, business analysis, and basic
bookkeeping and
accounting.
Since the value of things fluctuates over time, valuations are as of a
specific date like the end of the accounting quarter or year. They may
alternatively be
mark-to-market
estimates of the current value of assets or liabilities as of this
minute or this day for the purposes of managing portfolios and
associated financial risk (for example, within large financial firms
including
investment banks and stockbrokers).
Some balance sheet items are much easier to value than others.
Publicly traded stocks and bonds have prices that are quoted frequently
and readily available. Other assets are harder to value. For instance,
private firms that have no frequently quoted price. Additionally,
financial instruments that have prices that are partly dependent on
theoretical models of one kind or another are difficult to value. For
example, options are generally valued using the
Black–Scholes model while the liabilities of
life assurance firms are valued using the theory of
present value. Intangible business assets, like
goodwill and
intellectual property, are open to a wide range of value interpretations.
It is possible and conventional for financial professionals to make
their own estimates of the valuations of assets or liabilities that they
are interested in. Their calculations are of various kinds including
analyses of companies that focus on price-to-book, price-to-earnings,
price-to-cash-flow and
present value calculations, and analyses of bonds that focus on credit ratings, assessments of
default risk,
risk premia, and levels of
real interest rates.
All of these approaches may be thought of as creating estimates of
value that compete for credibility with the prevailing share or bond
prices, where applicable, and may or may not result in buying or selling
by market participants. Where the valuation is for the purpose of a
merger or acquisition the respective businesses make available further detailed financial information, usually on the completion of a
non-disclosure agreement.
It is important to note that valuation requires judgment and assumptions:
- There are different circumstances and purposes to value an asset
(e.g., distressed firm, tax purposes, mergers and acquisitions,
financial reporting). Such differences can lead to different valuation
methods or different interpretations of the method results
- All valuation models and methods have limitations (e.g., degree of complexity, relevance of observations, mathematical form)
- Model inputs can vary significantly because of necessary judgment and differing assumptions
Users of valuations benefit when key information, assumptions, and
limitations are disclosed to them. Then they can weigh the degree of
reliability of the result and make their decision.
Valuation of a suffering company
Additional adjustments to a valuation approach, whether it is
market-, income-, or asset-based, may be necessary in some instances
like:
- Excess or restricted cash
- Other non-operating assets and liabilities
- Lack of marketability discount of shares
- Control premium or lack of control discount
- Above- or below-market leases
- Excess salaries in the case of private companies
There are other adjustments to the financial statements that have to
be made when valuing a distressed company. Andrew Miller identifies
typical adjustments used to recast the financial statements that
include:
Valuation of intangible assets
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).
Valuation of mining projects
In
mining, valuation is the process of determining the value or worth of a mining property. 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. The CIMVal Standards ("
Canadian Institute of Mining, Metallurgy and Petroleum on Valuation of Mineral Properties") are a recognised standard for valuation of mining projects and is also recognised by the
Toronto Stock Exchange (Venture). The standards, spearheaded by K. Spence & Dr. W. Roscoe,
[3] 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. Depending on context,
Real options valuation techniques are also sometimes employed; for further discussion here see
Business valuation: Option pricing approaches,
Corporate finance: Valuing flexibility, as well as
Mineral economics
TANGAZO 23 Jan. 2015 (English)