Importance Of Valuation Analysis In Trading

Last Updated August 19th 2021
7 Min Read

Valuation Analysis

Whether it is about an asset you already own or wish to acquire, it is always important that you are aware of its value. This is all the more important when it comes to a business entity that needs to know the valuation of an asset it possesses or about one that it plans to acquire. 

This is the crux of valuation analysis, in laymen’s terms, and it helps to understand it better and the various means of using it and the models and methodologies used in the process. 

What Is Valuation Analysis?

The process of valuation analysis is an exercise conducted to assess the worth of an asset. This is applicable for multiple asset classes like equities, commodities, real estate and also businesses, besides others. Typically, the value that is assessed in the analysis is approximate but, depending on how well it is done, can give a close estimate too. 

This is a quantitative process that aims to arm a potential investor in a business or a buyer of a stock in a company with useful inputs about the fair value of that asset. With this analysis, he can arrive at a price that is a derivative of the intrinsic value of all the key components and variables that define the worth of the investment. 

Why Is Valuation Analysis Important?

The process of valuation analysis is open to many different models from which the user can pick one depending on his specific requirement. As every asset – be it a business or a stock or any other – is different, an analyst or an investor gets to customise the concept and its tools to his needs. The end use remains the same as the intent is to understand the worth and the future potential of the investment using its present value. 

The difference will lie in the approach taken and the model for valuation analysis adopted in each scenario. The model enables you to use a set of assumptions based on the present data available and throw in the required variables to arrive at a conclusion. 

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The Practical Relevance Of Valuation Models

It is fairly easy to find out the present market value of a business that is already being publicly traded. All the relevant data and reports are out there for any interested investor or shareholders to see and peruse. Even without additional documents or any serious number crunching, it is easier to ascertain the value of a company with a simple calculation. Multiplying the total number of outstanding shares of a company with the current stock exchange price gets you near enough. 

But with privately owned entities, assessing their value is not that straightforward and easy. In the absence of any information that is usually made public, getting an insight into the worth and health of the business can be difficult. This is where the practical use and relevance of valuation models come into play. 

If we were to understand the relevance and usability of these models that help analyse the value, we can approach this from two sides. One, from the standpoint of the business itself, there can be a set of requirements that warrant a valuation. Two, from the perspective of a potential investor too, there can be reasons to assess the worth of a future investment. 

For the business itself: 

  • They are looking to sell off the company and want to understand the actual valuation of their business to demand a price for it. 
  • They are considering taking on more investors and shareholders and infusing more capital into the business. For this, they need to assess the value of the business and what they should charge per share. 
  • The business is planning an expansion and, therefore, need to raise loans or finance a debt. This too will warrant an assessment of the business valuation. 
  • Or they simply want to understand and assess their standing or progress against their business plan as part of a stocktaking exercise. 

For an investor:

  • As an investor or someone who is intending to join the business with capital infusion, they need to ensure that they are investing in a healthy company.
  • Also, a valuation analysis can reassure them that their investment is fetching them a proportionate and lucrative deal for the money offered. 
  • It is also a good exercise in taking stock of the business and mutually understand the current situation and take the right decisions for future growth or course correction if need be.  

Models And Methodologies

While the objective remains the same, the approaches taken to analyse the value can vary from asset to asset. There is a range of valuation models and techniques available and their deployment depends on the exact requirement of each case. 

There are two basic categories that valuation models can be classified into. These encompass the various approaches that are possible to determine the value of an asset, with the routes being taken diametrically opposite to each other. 

Absolute valuation method

This is about a singular and absolute value being assessed which focuses only on the asset itself. The assessment here is based on the fundamentals of, say, a company or a commodity or a security. The targets of analysis here are points like the growth rate, cash reserves, dividends, cash flow and other parameters that are intrinsic to a company. There is no external reference point as would be the case if a competing company or stock were to be compared against the asset in question. 

Key methods used in Absolute Valuation

  • Dividend Discount Model: In this model, the assumption is that the dividend amount, due to the shareholders, in the future is used as the basis for ascertaining the future value of an enterprise. When discounted to the current levels of value, this model seeks to accurately estimate that subsequent cash flows will be at par with the future dividend amounts. 
    Here, the price of the stock of the company is treated as a negative cash flow whereas dividends are considered to be positive. 
  • Discounted Cash Flow Model: DCF or Discounted Cash Flow model focuses on estimating the value of an asset by determining its ability to generate cash flow. The intent here is to ascertain the total cash flow that the business is capable of accruing each year. To arrive at the net or the free cash flow, the money that is liable to be repaid by the company to its stakeholders need to be deducted. 
    When this is projected over future years after duly discounting it, we arrive at the valuation using this model. 
  • Residual income model: The Residual income model works with a more inclusive assumption of what comprises of cash flows. Under the Residual Income Model, any item of cash flow that is due to the business post third party payouts is considered. The only exception taken here is payout obligations to equity and bond stakeholders. 

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Relative valuation method

Unlike absolute valuation, relative valuation seeks to compare one company against another using various methods that involve ratios and other valuation tools. 

Comparable analysis: Assuming that similar securities are valued at the same prices, this model compares the multiples of a stock to a specific benchmark. Here, as a reference, the valuation metrics of other companies, especially in the same industry and governed by market prices, are used as a comparison. 

Precedent transactions: Another way of making a relative valuation is to compare your company with another in the same sector or industry and has undergone a similar process of sale or acquisition. These can be relevant only for a short period and may not be a good indicator over time. 

Given below are some of the more popular and tested methods of valuation that are used to assess the worth of a business using the underlying financials and stock prices:

Price to earnings: The simple definition for Price to earnings - P/E - is that it is the ratio of the price to net earnings. The price is usually applicable for the period when it is calculated for the trailing twelve months. In a formula sense, it reads as Price to earnings or P/E = Price of the stock/net earnings per share

Earnings per share: The Earnings per share (EPS) refers to the per share yield received on the earnings. 

Price earnings to growth ratio: Here, the price earnings to growth is a comparison to the company’s growth rate. A lower number is usually better. 

Price to sales: With respect to the share value for, say, a dollar’s worth, what is the business being generated? Again, a lower value is more desirable. 

Price to cash flow: This refers to the stock price in relation to the cash flow generated by the business. 

Any investor who seeks information or, better still, confirmation regarding the worth of an asset he is planning to buy should use valuation analysis. This is a good insight into the intrinsic value of the asset he is investing in. It helps him understand the current financial position of the company and the potential it holds from both a growth and risk perspective.

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