What is Valuation and why it is required?
Valuation is the pre-procedure of decision making to determine the worth of an asset. It helps run a business for choosing investments and financing by knowing reasonable estimates of value for assets. One can determine the values of all types of assets either it is real or financial. However, the process may differ from asset to asset.
Different Approaches to Valuation:
Generally, there are mainly the following approaches to valuation.
- Income Approach (Discounted Cashflow Valuation): This approach co-relates the value of an asset with the present value of expected future cash flows on that asset.
- Market Approach (Relative Valuation): This approach compares the relative asset by looking at a pricing of comparable assets where common variables like earnings, cash flows, or sales are taken into account.
- Cost Approach: This approach is based on replacement or reproduction cost for similar assets.
- Contingent Claim Valuation: It uses pricing models to measure the value of assets that share option characteristics.
Discounted Cash Flow Models are categorized into three models:
- Going Concerned and Asset Valuation: There is a difference between valuing a collection of assets and valuing a business. For a business, in an on-going entity with assets, estimation for existing investments but as well as expected future investments are needed. One of the special cases of asset-based valuation is liquidation valuation, which is calculated after a presumption that assets have been sold.
- Equity Valuation and Firm Valuation: In a firm valuation the estimation for both assets-in-place and growth assets is made to value the whole business. The cash flows before debt payments and reinvestment needs are known as free cash flows, and the discount rate that reflects the cost of financing from different sources of capital is called the cost of capital. On the other hand, only equity stakes in the business are valued in equity valuation. The cash flows after debt payments and reinvestment needs are called free cash flows to equity, and the discount rate that reflects just the cost of equity financing is the cost of equity.
- Variations in DCF Models: Main three inputs are required in this model: the expected cash flow, the timing of the cash flow, and the discount rate. This method requires analysts to understand the businesses for the long term to find out the sustainability of cash flows and risk.
Why Valuation is required?
Valuation plays a vital role in any business mainly for portfolio management, acquisition analysis, and corporate finance.
Portfolio Management: Although Passive investors aren’t much rely on it, it plays a significant role for an active investor. It helps in keeping an eye on financial characteristics like business growth, risk areas, and cashflows.
Valuation in Acquisition Analysis: This makes an individual decide a fair value for the target business or the business owner to know the reasonable value of their business. It depends on the two factors: first is an increase in value after combining the two firms; second is the value of the control. There may be a change in the value after restructuring any business or change in management which has to be considered before deciding any fair value.
However, there is no one exact way to value a business including Income, Assets, and Market. But when done correctly, valuation can help to price the right deal and investment.