What is Valuation?

Valuation is like a complicated math problem…

In a math exam, you might run into a complicated problem that requires you to add, subtract, divide, and multiply a broad set of numbers before arriving at a final answer. The valuation process is like a big math problem, in which you look at many aspects of a business and assign a numerical value to each. Then, you add those values together to arrive at your theoretical estimate of a company’s overall worth.

Valuation is the process of figuring how much an asset or business is worth. In the world of finance, valuation is an important process that can help investors decide whether to buy or sell a stock and new companies determine their value.

There are many ways (aka valuation methods) to determine the value of a company. Investors look at things like the company's list of assets and liabilities, its earnings, and how it compares to the value of similar companies. Each valuation method has its advantages and drawbacks, and investors may use multiple strategies when analyzing a single company.

Keep in mind that valuation isn't an exact science. There's no correct answer as to how much a company or asset should cost. Even when analyzing the same company, different analysts may produce different answers. Likewise, different valuation methods can value businesses differently. For example, one method might look at a firm’s cash flow while another could look at its assets. An asset-poor, but cash flow rich would have very different valuations depending on the method used.

What an investor is willing to pay also plays a role. A valuation may conclude that a company should be worth $1 million, but buyers may only want to pay $500,000 for the business. Think of valuation as a tool that investors use to get an idea of what a company should be worth. In some cases, valuation can help investors find companies that may be over- or undervalued.

There are many purposes of valuation for a company or an asset. When an investor buys an asset, their goal is to try to make sure that the price they pay is reasonable. Let’s say you’re looking to get a mortgage so you can buy a house. Your lender wants to have an appraiser examine the house you want to buy to get an idea of its value. If the seller is asking for $500,000, but the appraiser estimates the home's value is only $250,000, the lender might not approve the deal. But if the home appraises for $500,000, that signals to the lender that the home is worth the seller’s price.

This is the basic idea of a valuation. Investors often use it to decide whether they should buy or sell shares in a company. For example, if a company’s market capitalization is $1B, and the investor's assessment says the firm is worth $2B, the investor may decide that the market is undervaluing the company and decide to buy. But if a valuation instead showed that the company was worth less, like $500M, the investor may decide it isn’t worth buying shares.

Startups also use valuation as they prepare to attract funding from potential investors. The process can help a startup estimate how much they can expect to receive from investors for a stake in the company. Because private companies can't rely on public stock exchanges to produce a market value of their shares, the valuation process can be a helpful way to determine how much shares should cost before a company goes public.

A company’s leadership may also use a valuation to motivate employees. If a business runs valuations on a regular basis, it may be able to track whether it is gaining or losing value. Showing the effects of employees’ work on the value of the company may help motivate them.

A valuation process produces a dollar value for a business or other assets. In short, it tells you how much something might be worth. Keep in mind that valuation is like taking a well-informed guess — The result is still theoretical. In other words, valuation can’t tell you the absolute value of a company, because there’s no right answer. There are many different ways to value a company, each with their own set of assumptions and variables. Changing even one assumption can produce a different answer. Instead, the valuation process offers a good starting point and a reference that an investor can use to make other decisions, like whether to buy or sell shares.

There are multiple ways to value a company, each looking at different aspects of a company and its operations.

One of the simplest ways to value a business involves looking at the company's assets and liabilities. Let’s say you’re interested in buying shares of a company that has assets worth $250M and $100M in debt. An asset-based valuation method may tell you that the company should be worth at least $150M (value of the company’s assets – the value of its debt).

The benefit of this approach is that it’s simple and quick. But there are several potential drawbacks to this method. For example, asset-based valuation strategies typically assume that a company will continue to exist and operate precisely as it does now. It also doesn't account for more ephemeral factors like branding and good will, which can account for a large portion of a business's value. It also ignores cash flows, which are an important part of a firm’s value, but not relevant if you plan to liquidate the company.

That said, asset-based approaches can be useful when you're trying to find a company’s liquidation value. It gives you an idea of how much cash you'd get if you sold everything the business owned and paid off its debts.

Discounted cash flow offers a more in-depth valuation approach that can produce a more complete estimate. Instead of assessing what a company’s assets are worth, this method looks at the company's income and expenses, to determine its future cash flows and assign a value to the flow of cash.

Looking at cash flows is a popular method for valuing businesses. Discounted cash flow typically follows these steps:

1. Figure out the company’s future revenues (through forecasting or assumptions). Then calculate its planned expenses and changes to capital assets (like equipment).
2. Determine the terminal (aka end) value of the company's cash flow after the period that you forecast using the following formula:

Terminal value = Cash flow / (discount rate - assumed growth rate)

1. Use the Net Present Value formula to find out the current value of those future cash flows:

Discounted cash flow valuation methods can be more complete than asset-based ones because they look at more than just the company’s assets and debts. They're also more flexible because they rely on forecasts, rather than past data. An investor may run multiple valuations using different assumptions to examine different scenarios.

But there’s also a downside to this method’s flexibility. Because it relies on assumptions and estimates, there may be a lot of room for error — Producing a valuation that's too high or too low. Discounted cash flow also involves a lot more math, making it more complicated to use than an asset-based approach.

More often than not, a company has competitors in its industry. Looking at the value of competitors is another way to estimate a company’s value. In a comparable company analysis, an assessor looks at many similar businesses to determine a company’s value. For example, if an investor is trying to determine the value of a new coffee shop, it might look at other coffee shops in the area that recently sold and the price their buyers paid.

Comparable analysis is often used in real estate, as home buyers and sellers often look to the prices of similar homes in the same area when negotiating a price. Comparable company analysis can be useful because it’s related to the market value of a business. The idea is that, if someone was willing to pay $500,000 for a similar company last week, there’s a good chance that someone will pay about that much this week.

One limitation of comparable company analysis is when there aren’t any or enough competitors or similar businesses, like in a new industry. In some cases, there may not be enough data available to do a meaningful analysis. Another limitation of this method is that it doesn’t do a good job of accounting for the fact that no two companies are the same. There are many intangible factors that can be difficult to compare, like the company’s quality of management, employee experience, branding, and goodwill.

In some cases, an investor might try to determine a company’s value by calculating the cost of starting a new company in the same industry. Let’s say you’re a restauranteur looking to open a ramen shop. Instead of acquiring an existing one, you could try to figure out how much it would cost to start a new restaurant from scratch. You might add up major costs, like buying or leasing a space, purchasing equipment, and other expenses like training and branding. The math may be relatively simple, but the cost of a start up approach also has its limitations. For example, it doesn’t consider many other factors that add value to an existing business, like customer loyalty or employee experience.

The biggest limitation of the company valuation process is that there’s no such thing as a correct answer. Because there are many ways to perform a valuation, there are many answers, each with their own advantages and limitations. Many valuation methods don’t take into account certain aspects of a company that are pretty important, or they rely on forecasts and assumptions. Both of these limitations leave room for error. Even when looking at the same business, different techniques can produce different valuations, which can lead to contradictory analyses. And valuation methods may produce answers that differ from the market price — The value at which you can buy or sell a company’s shares on the market).

In addition, valuation doesn’t necessarily help an investor identify the investment that will perform better than any other. The process can be more useful for analyzing whether or not a particular investment opportunity is worth considering. And even if a valuation can help an investor determine if one particular investment opportunity is a good deal, it won’t necessarily help determine if another opportunity may be even better.

One way an investor might try to get around these limitations is by using multiple valuation methods on a single company. For example, valuing a company using both an asset-based approach and the discounted cash flow method allows an investor to look at the firm's value in two ways. This may show a more complete picture than using just one method.