Valuation (Finance)

Valuation is the process of estimating what an asset, a business or a security is worth. It is used when companies are bought and sold, when shares are priced for an initial public offering, when start-ups raise money, when funds report the value of their holdings, and in tax, accounting and legal disputes. The result is an estimate of value, which can differ from the price at which the asset actually changes hands.

Practitioners group the methods into three families: the income approach, which discounts expected future cash; the market approach, which compares the asset with similar ones that have a known price; and the asset (or cost) approach, which adds up what the underlying assets are worth. The International Valuation Standards Council (IVSC) uses the same three-way split, and accounting standards such as IFRS 13 and US ASC 820 define the "fair value" that financial statements must report.

Pricing a flat for sale shows all three methods at work. An estate agent looks at what similar flats on the same street sold for. A landlord asks how much rent the flat will bring in each year and what that stream of rent is worth today. An insurer asks what it would cost to rebuild the flat from scratch. Each answer is reasonable, and they rarely match exactly.

Valuing a company works the same way. Analysts look at what similar businesses trade for, estimate the cash the business will generate, and tally what its assets would fetch. Where the three answers land, and how far apart they are, tells the buyer how confident to be.

The discounted cash flow (DCF) method values an asset as the present value of the cash flows it is expected to produce, with later cash worth less than earlier cash. The standard calculation is:

• $V$ is the value today.
• $CF_t$ is the cash flow expected in year $t$, usually free cash flow after investment.
• $r$ is the discount rate, typically the weighted average cost of capital for a whole firm or the cost of equity for its shares; it builds on the risk-free rate plus a premium for risk.
• $n$ is the number of years forecast explicitly.
• $TV$ is the terminal value, the worth of all cash flows after year $n$, often estimated as $CF_{n+1} \div (r - g)$ with $g$ a modest long-run growth rate.

Worked example: a business is expected to generate 100 a year for three years, then grow at 2% a year for ever, and the discount rate is 10%. The three annual cash flows are worth $90.91 + 82.64 + 75.13 = 248.68$ today. The terminal value at year three is $102 \div 0.08 = 1{,}275$, worth $1{,}275 \div 1.331 \approx 957.93$ today. The total value is about 1,206.6. Raising the discount rate to 11% would cut that figure to about 1,073, roughly 11% less, which shows how sensitive DCF results are to their assumptions. The method gives an estimate of intrinsic value rather than of market price.

The market approach applies a ratio taken from similar companies or deals. Common multiples include:

• The price-to-earnings ratio, comparing share price with profit per share.
• The price-to-book ratio, widely used for banks and insurers.
• Enterprise value to EBITDA, which compares the whole firm, including its debt, with operating profit before depreciation.
• Revenue multiples, often used for young businesses that do not yet make a profit.

"Trading comparables" use the multiples of listed peers, read from their market capitalization and accounts. "Precedent transactions" use prices paid in past takeovers, which usually include a control premium above the pre-bid share price. The approach is quick and grounded in real prices, but it inherits any mispricing in the market it borrows from.

The asset approach values a company by its assets minus its liabilities, each restated at current value where possible. It suits holding companies, property firms, investment trusts and businesses in run-off or insolvency, where the parts are worth more than the earnings stream. Variants include going-concern net assets, liquidation value (what the assets would fetch in a forced sale) and replacement cost. Investment funds use the same logic daily when they publish their net asset value.

IFRS 13 Fair Value Measurement and the equivalent US standard, ASC 820, define fair value as the price that would be received to sell an asset in an orderly transaction between market participants. Both rank the inputs in a three-level hierarchy: Level 1 is a quoted price in an active market, Level 2 uses observable inputs such as prices of similar assets, and Level 3 relies on unobservable inputs and models. Assets carried at mark-to-market values sit mainly in Levels 1 and 2.

In private markets, venture capital and private equity investors negotiate "pre-money" and "post-money" valuations for each funding round, and a SAFE often sets a valuation cap rather than a price. In the United States, companies granting stock options usually commission an independent appraisal of their common stock, known as a 409A valuation after the tax code section it relates to. Crypto markets use fully diluted valuation, which multiplies the token price by the maximum future supply. Every method depends on judgement, so lenders and acquirers test the result through due diligence before relying on it.

• IFRS Foundation: IFRS 13 Fair Value Measurement
• International Valuation Standards Council: International Valuation Standards