Definition of valuation
Valuation, in finance means the process by which the value of something is estimated. In case of businesses, the value of financial assets and liabilities are usually estimated. Valuation of both tangible and intangible assets is done. Tangible assets include land, building, investments in marketable securities and many more. Some of the examples of intangible assets are goodwill, trademark and patent. Liabilities such as bonds issued by company are also valued.
There are many reasons for which valuation is needed. Some of them are merger and acquisition transaction, capital budgeting, financial reporting, investment analysis, in litigation and taxable events for determining proper tax liability.
Types of models used for valuation of financial assets
1) Absolute value model – this model determines the expected future cash flows from the present value of an asset. This model focuses on mathematics and not on price observation. There are mainly two general forms of this model, first is the multi-period model like the discounted cash flow model and second is the single-period model like the Gordon model.
2) Relative value model – this model determines the value of an asset on the basis of market price observation of assets of similar type.
3) Option pricing model – this model of valuation is a complex type of present value model and it is used for determining the worth of specific types of financial assets. Some of these assets are employee stock options, warrants, call options, put options, callable bonds, etc. Option pricing models are of many types and the most common of them are lattice models and Black-Scholes-Merton models.
Methods of valuation
1) Time value of money – in this method the value of an asset is estimated on the basis of the expected future cash flows which are then discounted to the present value.
2) Net asset value method - this method takes into account both assets and liabilities of a company. Under this method a solvent company would be able to shut down its operations, sell its assets and pay its creditors at a minimum and any remaining cash will be the floor value for the company. This method is used for companies that are not performing well having many tangible assets, for non-profit organizations and for valuing heterogeneous portfolios of investment.
3) Guideline companies method – under this method, a company’s value is determined by observation of prices of guideline companies that is similar companies.
- Debt ratios
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