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.

Investors in a suffering company, or in other "distressed securities", may intend (i) to restructure the business, with the valuation reflecting its potential thereafter, or (ii) to purchase the company - or its debt - at a discount, as part of an Investment Strategy aimed at realizing a profit on recovery.

Preliminary to the valuation, the financial statements are initially recast, to "better reflect the firm's indebtedness, financing costs and recurring earnings".[8] Here adjustments are made to working capital, deferred capital expenditures, cost of goods sold, non-recurring professional fees and costs, above- or below-market leases, excess salaries in the case of private companies, and certain non-operating income/expense items.[9]

The valuation is built on this base, with any of the standard market-, income-, or asset-based approaches employed. Often these are used in combination, providing a "triangulation" or (weighted) average. Particularly in the second case above, the company may be valued using real options analysis, serving to complement (or sometimes replace) this standard value; see Business valuation § Option pricing approaches and Merton model.

As required, various adjustments are then made to this result, so as to reflect characteristics of the firm external to its profitability and cash flow. These adjustments consider any lack of marketability resulting in a discount, and re the stake in question, any control premium or lack of control discount. Balance sheet items external to the valuation, but due to the new owners, are similarly recognized; these include excess (or restricted) cash, and other non-operating assets and liabilities.

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.[10] 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.[11] Valuation using discounted cash flows discusses various considerations here.

The valuation of early-stage startups can be more nuanced due to their lack of established track records. One common approach is using comparative valuations, although this method can be less accurate given the uniqueness of each startup [12]. Some methods adjust the average pre-money valuation of pre-revenue startups based on various attributes within the same market[13]. Average pre-money valuations in a particular region or sector, obtained from recent market deals, can also serve as reference points[14]. During Series A funding rounds, the typical valuation for startups is reported to be between $10 million to $15 million[15]

Valuation models can be used to value intangible assets such as for patent valuation, but also in copyrights, software, trade secrets, and customer relationships.[16] As economies are becoming increasingly informational, it is recognized that there is a need for new methods to value data, another intangible asset.

Valuations here are often necessary both for financial reporting and intellectual property transactions. They are also inherent in securities analysis - listed and private - in cases where analysts must estimate the incremental contribution of patents (etc) to equity value; see next paragraph. 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 by estimating the cost of recreating the asset in question. In some cases,[17] option-based techniques or decision trees may be applied. Regardless of the method, the process is often time-consuming and costly. If required, stock markets can give an indirect estimate of a corporation's intangible asset value: this can be reckoned as the difference between its market capitalisation and its book value (including only hard assets), i.e. effectively its goodwill; see also PVGO.

As regards listed equity, the above techniques are most often applied in the biotech-, life sciences- and pharmaceutical sectors [18] [19] [20] (see List of largest biotechnology and pharmaceutical companies). These businesses are involved in research and development (R&D), and testing, that typically takes years to complete, and where the new product may ultimately not be approved (see Contingent value rights). Industry specialists thus apply the above techniques - and here especially rNPV - to the pipeline of products under development, and, at the same time,[16] also estimate the impact on existing revenue streams due to expiring patents. For relative valuation,[18] a specialized ratio is R&D spend as a percentage of sales. Similar analysis may be applied to options on films re the valuation of film studios.

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 valuing a mining project or mining property, fair market value is the standard of value to be used. In general, [21] this result will be a function of the property's "reserve" - the estimated size and grade of the deposit in question - and the complexity and costs of extracting this.[22] [23]

"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 [24]) 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 [25] for further discussion and context. Real Options analysis [26] [27] is sometimes [21] [25] [26] used when there is a need to evaluate the project under different scenarios from inception.

Analyzing listed mining corporates (and other resource companies) is also specialized,[22] as the valuation requires a good understanding of the company's overall assets, its operational business model as well as key market drivers,[28] and an understanding of that sector of the stock market.[22] Re the latter, a distinction is usually made based on size and financial capabilities; see Mining § Corporate classifications.

• The price of a "Junior" mining stock, typically having one asset, will at its early stages be linked to the result of its feasibility study; later, the price will be a function of that mine's viability and value, largely applying the above techniques.
• A "Major", on the other hand, has numerous properties, and the contents of any single deposit will impact stock value in a limited fashion; this due to diversification, access to funding, and, also, since the share price inheres goodwill. Typically, then, the exposure is more to the market value of each mineral in the portfolio, than to the individual properties.

There are two main difficulties with valuing financial services firms. [29] [30] [31] 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."[29] (See related discussion re. the risk management of financial- vs non-financial firms.) The second is that these firms operate under a highly regulated environment, 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 EBITDA 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. Here, there are also industry-specific measures used to compare between investments and within sub-sectors; this, once normalized by market cap (or other appropriate result), and recognizing regulatory differences:

• Insurance companies: embedded value and actuarial reserves
• Banking sector: net interest margin and provision for credit losses
• Wealth- and investment management firms: assets under management
• Investment banks: price to tangible book value and return on tangible equity.