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In finance, valuation is the process of estimating the potential market value of 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 required in many contexts including investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.

Contents

Valuation overview

Valuation of financial assets is done using one or more of these types of models:

  1. Discounted Cash Flows determine the value by estimating the expected future earnings from owning the asset discounted to their present value.
  2. Relative value models determine the value based on the market prices of similar assets.
  3. 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 fair market value, fair value, and intrinsic value. The meanings of these terms differ. The most common sets market price. For instance, when an analyst believes a stock's intrinsic value is greater than its market price, the analyst makes a "buy" recommendation and vice versa. Moreover, an asset's intrinsic value may be subject to personal opinion and vary among analysts.

For a comprehensive discussion on financial valuation see Aswath Damodaran, Investment Valuation, (New York: John Wiley & Sons, 2002).

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 (US), 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) often show the values of assets at 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 values of some types of assets—securities held for sale, for instance—at their market values rather than at cost. When a firm is required to show some of its assets at market value, some call this process "mark-to-market." But reporting asset values on financial statements at market values gives managers ample opportunity to slant asset values upward—to artificially increase profits and stock prices. Managers may be motivated to alter earnings upward so they can earn bonuses. Despite the risk of manager bias, investors and creditors prefer to know the market values of a firm's assets—rather than their costs—because the current values give them better information to make decisions.

Main business valuation Method

Discounted cash flows 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 monies 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. Some people call this percentage a discount rate.

The idea of opportunity cost can be illustrated in an example. A person with only $100 to invest can make just one $100 investment even when presented with two or more investment choices. If this person is later offered an alternative investment choice, the investor has lost the opportunity to make that second investment since the $100 is spent to buy the first opportunity. This example illustrates that money is limited and people make choices in how to spend it. By making a choice, they give up other opportunities.

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 principle 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 (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 value ratios. Next, one or more price multiples are 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.

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 e.g., 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-cashflow 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 very important to note that valuation is more an art than a science because it requires judgement:

  1. There are very different situations and purposes in which you value an asset (e.g. company in distress, tax purposes, mergers & acquisitions, quarterly reporting). In turn this requires different methods or a different interpretation of the same method each time.
  2. All valuation models and methods have their limitations (e.g., mathematical, complexity, simplicity, comparability) and could be widely criticized. As a general rule the valuation models are most useful when you use the same valuation method as the "partner" you are interacting with. Mostly the method used is industry or purpose specific;
  3. The quality of some of the input data may vary widely
  4. In all valuation models there are a great number of assumptions that need to be made and things might not turn out the way you expect. Your best way out of that is to be able to explain and stand for each assumption you make;

When a valuation is prepared all assumptions should be clearly stated, especially the context. It is improper, for example, to value a going concern, based on an assumption that it is going out of business, since then only a salvage value remains.

Valuation of a distressed company

Additional adjustments to a valuation approach, whether it is market-, income- or asset-based, may be necessary in some instances. These involve:

  • excess or restricted cash
  • other non-operating assets and liabilities
  • lack of marketability discount
  • 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:

  • working capital adjustment
  • deferred capital expenditures
  • cost of goods sold adjustment
  • non-recurring professional fees and costs
  • certain non-operating income/expense items.[1]

Valuation of intangible assets

Valuation models can be used to value intangible assets such as patents, 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 & 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 are a recognised standard for valuation of mining projects and is also recognised by the Toronto Stock Exchange (Venture). The standards spearheaded by Spence & Roscoe, 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.

Asset pricing models

See also Modern portfolio theory

See also

References

  1. ^ Joseph Swanson and Peter Marshall, Houlihan Lokey and Lyndon Norley, Kirkland & Ellis International LLP (2008). A Practitioner's Guide to Corporate Restructuring, Andrew Miller’s Valuation of a Distressed Company page 24. ISBN 9781905121311

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