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Main Dictionary V

Valuation

A valuation is called the analysis estimating current and projected value of assets or enterprises. A vast deal of techniques is applied during the valuation process. Experts assessing a company pay regard to the business administration, capital composition, future expectations for income receivable, as well as intrinsic value. 

As a rule, the valuation process brings into requisition a fundamental analysis. Other methods are also considered, including a capital asset pricing model and a dividend discount model. 

Essence of Valuation

Usually, a valuation implies establishing a security fair value, which is set by the amount of financial facilities that a buyer is ready to give to the sales person. A key element for the transaction is a mutual agreement of both parties. During the security trading process, participants estimate a stock or a bond market value.

Anyway, the term “intrinsic value” signifies a perceived cost of a security paper centered around the prospective earnings or other enterprise properties that are not connected with its market price. So, the valuation gets the lead out. As it was already mentioned, experts carry out a valuation process in order to recognise, if the asset can be overvalued or undervalued by the market. 

Division of Valuation

In fact, there exists two major types of the valuation process:

  1. Relative valuation framework. An operating principle contemplates identifying similarities and contrasts between chosen enterprise and its rivals. The technique presupposes multiples and ratios correlation. For instance, there is a PE multiple that means a price-to-earnings coefficient. The PE ratio can vary depending on the enterprise. So, in case the first firm has a higher multiple than the second, the initial company is considered overvalued. 
  2. Absolute valuation framework. Fundamentals come into play in order to determine the intrinsic value of all investments. It concerns dividends, financial flow, and the growth pace of a particular enterprise, but it doesn’t take into account the performance of other firms. So that several models can be included in this framework: a dividend discount, a residual revenue, as well as discounted monetary flows.

Correlation between Valuation and earnings

Basic earnings per ordinary share (EPS) formula may be described as financial return for stockholders segmented by the amount of common shares in circulation. It is a marker of the enterprise gains, as the higher earnings a firm is able to produce, the more worthwhile each share would be to the investor. 

Moreover, experts apply a price-to-earnings ratio for stock valuation. The indicator should be calculated by defining a market cost per share splitted up by EPS. Therefore, it identifies the cost intensiveness of a share in regards to the earnings. 

A case in study can be the P/E coefficient that 20 times exceeds the earnings. That’s where experts start to compare the P/E of the firm with other enterprises’ indicators. Notably, the industry should be the same, while the broader market is also studied. 

Valuation techniques

Lots of techniques for carrying out the valuation process are of great importance, but let’s consider the key ones:

  • Direct capitalization. This approach to business valuation is used in case the expert has carried out an analysis of financial and economic activities. A basic premise is the reason to believe that the enterprise efficiency will be maintained in the period ahead. 
  • Analysis of discounted monetary flows. Being a financial model, it is often used to estimate the total value of a business. Thereby, the firm’s value is determined by assessing its future cash flows. Discounting allows one to determine whether the investor would lose certain financial facilities in a particular scenario, or would be able to solve the situation for its own benefit. So, in other words, the discounted cash flow means the analysis of a prospective enterprise value, taking into account inflation, risks, alternative income, etc. DCF is considered the most versatile method. However, its key disadvantage is that even small inaccuracies or an error in the source data can lead to large changes in the business valuation.
  • Method of net assets. The task of the expert is to analyze the assets and liabilities composition in the balance sheet. Then identify those that can be used in the calculation in a costly way. A person sums up the market value of assets, subtracting the liabilities cost.
  • Comparable company analysis. The method presupposes estimating the enterprise peers, according to their size, sector and trading process. The purpose lies in specifying a fair market value of the firm. 
  • Salvage value method. Applied if the object of valuation is a liquidated business. The specialist determines how much assets will be sold separately. The cost of dismantling, preservation of finished products until sale, salaries of employees who work until liquidation, etc. are deducted from the sum of all assets.
  • Industry ratios method. The specialist works with sectoral coefficients, which are derived during the extensive analysis of businesses. The method provides objective results, but is applicable mainly to small firms. The calculation is based on the ratio of the object price and its financial indicators (profit, revenue, net income, reserves, etc.).

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