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In finance, valuation is the process of determining the present value (PV) of an asset. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company). Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.
Finance is a field that is concerned with the allocation (investment) of assets and liabilities over space and time, often under conditions of risk or uncertainty. Finance can also be defined as the art of money management. Participants in the market aim to price assets based on their risk level, fundamental value, and their expected rate of return. Finance can be split into three sub-categories: public finance, corporate finance and personal finance.
In economics and finance, present value (PV), also known as present discounted value, is the value of an expected income stream determined as of the date of valuation. The present value is always less than or equal to the future value because money has interest-earning potential, a characteristic referred to as the time value of money, except during times of negative interest rates, when the present value will be more than the future value. Time value can be described with the simplified phrase, "A dollar today is worth more than a dollar tomorrow". Here, 'worth more' means that its value is greater. A dollar today is worth more than a dollar tomorrow because the dollar can be invested and earn a day's worth of interest, making the total accumulate to a value more than a dollar by tomorrow. Interest can be compared to rent. Just as rent is paid to a landlord by a tenant without the ownership of the asset being transferred, interest is paid to a lender by a borrower who gains access to the money for a time before paying it back. By letting the borrower have access to the money, the lender has sacrificed the exchange value of this money, and is compensated for it in the form of interest. The initial amount of the borrowed funds is less than the total amount of money paid to the lender.
In financial accounting, an asset is any resource owned by the business. Anything tangible or intangible that can be owned or controlled to produce value and that is held by a company to produce positive economic value is an asset. Simply stated, assets represent value of ownership that can be converted into cash. The balance sheet of a firm records the monetary value of the assets owned by that firm. It covers money and other valuables belonging to an individual or to a business.
Common terms for the value of an asset or liability are market value, fair value, and intrinsic value. The meanings of these terms differ. For instance, when an analyst believes a stock's intrinsic value is greater (or less) than its market price, an analyst makes a "buy" (or "sell") recommendation. Moreover, an asset's intrinsic value may be subject to personal opinion and vary among analysts. The International Valuation Standards include definitions for common bases of value and generally accepted practice procedures for valuing assets of all types. Regardless, the valuation itself is done generally using one or more of the following approaches; but see also, Outline of finance #Valuation:
Market value or OMV is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with open market value, fair value or fair market value, although these terms have distinct definitions in different standards, and may or may not differ in some circumstances.
In accounting and in most Schools of economic thought, fair value is a rational and unbiased estimate of the potential market price of a good, service, or asset. It takes into account such objectivity factors as:
In finance, intrinsic value refers to the value of a company, stock, currency or product determined through fundamental analysis without reference to its market value. It is also frequently called fundamental value. It is ordinarily calculated by summing the discounted future income generated by the asset to obtain the present value. It is worthy to note that this term may have different meanings for different assets.
In finance, valuation analysis is required for many reasons including tax assessment, wills and estates, divorce settlements, business analysis, and basic bookkeeping and accounting. Since the value of things fluctuates over time, valuations are as of a specific date like the end of the accounting quarter or year. They may alternatively be mark-to-market estimates of the current value of assets or liabilities as of this minute or this day for the purposes of managing portfolios and associated financial risk (for example, within large financial firms including investment banks and stockbrokers).
An estate, in common law, is the net worth of a person at any point in time alive or dead. It is the sum of a person's assets – legal rights, interests and entitlements to property of any kind – less all liabilities at that time. The issue is of special legal significance on a question of bankruptcy and death of the person.
Divorce, also known as dissolution of marriage, is the process of terminating a marriage or marital union. Divorce usually entails the canceling or reorganizing of the legal duties and responsibilities of marriage, thus dissolving the bonds of matrimony between a married couple under the rule of law of the particular country or state. Divorce laws vary considerably around the world, but in most countries divorce requires the sanction of a court or other authority in a legal process, which may involve issues of distribution of property, child custody, alimony, child visitation / access, parenting time, child support, and division of debt. In most countries, monogamy is required by law, so divorce allows each former partner to marry another person.
In law, a settlement is a resolution between disputing parties about a legal case, reached either before or after court action begins. The term "settlement" also has other meanings in the context of law. Structured settlements provide for future periodic payments, instead of a one time cash payment.
Some balance sheet items are much easier to value than others. Publicly traded stocks and bonds have prices that are quoted frequently and readily available. Other assets are harder to value. For instance, private firms that have no frequently quoted price. Additionally, financial instruments that have prices that are partly dependent on theoretical models of one kind or another are difficult to value. For example, options are generally valued using the Black–Scholes model while the liabilities of life assurance firms are valued using the theory of present value. Intangible business assets, like goodwill and intellectual property, are open to a wide range of value interpretations.
Goodwill in accounting is an intangible asset that arises when a buyer acquires an existing business. Goodwill represents assets that are not separately identifiable. Goodwill does not include identifiable assets that are capable of being separated or divided from the entity and sold, transferred, licensed, rented, or exchanged, either individually or together with a related contract, identifiable asset, or liability regardless of whether the entity intends to do so. Goodwill also include contractual or other legal rights regardless of whether those are transferable or separable from the entity or other rights and obligations. Examples of identifiable assets that are goodwill include a company’s brand name, customer relationships, artistic intangible assets, and any patents or proprietary technology. The goodwill amounts to the excess of the "purchase consideration" over the total value of the assets and liabilities. It is classified as an intangible asset on the balance sheet, since it can neither be seen nor touched. Under US GAAP and IFRS, goodwill is never amortized. Instead, management is responsible for valuing goodwill every year and to determine if an impairment is required. If the fair market value goes below historical cost, an impairment must be recorded to bring it down to its fair market value. However, an increase in the fair market value would not be accounted for in the financial statements. Private companies in the United States, however, may elect to amortize goodwill over a period of ten years or less under an accounting alternative from the Private Company Council of the FASB.
Intellectual property (IP) is a category of property that includes intangible creations of the human intellect. There are many types of intellectual property, and some countries recognize more than others. The most well-known types are copyrights, patents, trademarks, and trade secrets. It was not until the 19th century that the term "intellectual property" began to be used, and not until the late 20th century that it became commonplace in the majority of the world.
It is possible and conventional for financial professionals to make their own estimates of the valuations of assets or liabilities that they are interested in. Their calculations are of various kinds including analyses of companies that focus on price-to-book, price-to-earnings, price-to-cash-flow and present value calculations, and analyses of bonds that focus on credit ratings, assessments of default risk, risk premia, and levels of real interest rates. All of these approaches may be thought of as creating estimates of value that compete for credibility with the prevailing share or bond prices, where applicable, and may or may not result in buying or selling by market participants. Where the valuation is for the purpose of a merger or acquisition the respective businesses make available further detailed financial information, usually on the completion of a non-disclosure agreement.
For an individual, a risk premium is the minimum amount of money by which the expected return on a risky asset must exceed the known return on a risk-free asset in order to induce an individual to hold the risky asset rather than the risk-free asset. It is positive if the person is risk averse. Thus it is the minimum willingness to accept compensation for the risk.
The real interest rate is the rate of interest an investor, saver or lender receives after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate.
Mergers and acquisitions (M&A) are transactions in which the ownership of companies, other business organizations, or their operating units are transferred or consolidated with other entities. As an aspect of strategic management, M&A can allow enterprises to grow or downsize, and change the nature of their business or competitive position.
It is important to note that valuation requires judgment and assumptions:
Users of valuations benefit when key information, assumptions, and limitations are disclosed to them. Then they can weigh the degree of reliability of the result and make their decision.
Businesses or fractional interests in businesses may be valued for various purposes such as mergers and acquisitions, sale of securities, and taxable events. An accurate valuation of privately owned companies largely depends on the reliability of the firm's historic financial information. Public company financial statements are audited by Certified Public Accountants (USA), Chartered Certified Accountants (ACCA) or Chartered Accountants (UK and Canada) and overseen by a government regulator. Alternatively, private firms do not have government oversight—unless operating in a regulated industry—and are usually not required to have their financial statements audited. Moreover, managers of private firms often prepare their financial statements to minimize profits and, therefore, taxes. Alternatively, managers of public firms tend to want higher profits to increase their stock price. Therefore, a firm's historic financial information may not be accurate and can lead to over- and undervaluation. In an acquisition, a buyer often performs due diligence to verify the seller's information.
Business is the activity of making one's living or making money by producing or buying and selling products. Simply put, it is "any activity or enterprise entered into for profit. It does not mean it is a company, a corporation, partnership, or have any such formal organization, but it can range from a street peddler to General Motors."
A privately held company, private company, or close corporation is a business company owned either by non-governmental organizations or by a relatively small number of shareholders or company members which does not offer or trade its company stock (shares) to the general public on the stock market exchanges, but rather the company's stock is offered, owned and traded or exchanged privately or over-the-counter. More ambiguous terms for a privately held company are closely held corporation, unquoted company, and unlisted company.
A public company, publicly traded company, publicly held company, publicly listed company, or public limited company is a company whose ownership is dispersed among the general public in many shares of stock which are freely traded on a stock exchange or in over-the-counter markets. In some jurisdictions, public companies over a certain size must be listed on an exchange. A public company can be listed or unlisted.
Financial statements prepared in accordance with generally accepted accounting principles (GAAP) show many assets based on their historic costs rather than at their current market values. For instance, a firm's balance sheet will usually show the value of land it owns at what the firm paid for it rather than at its current market value. But under GAAP requirements, a firm must show the fair values (which usually approximates market value) of some types of assets such as financial instruments that are held for sale rather than at their original cost. When a firm is required to show some of its assets at fair value, some call this process "mark-to-market". But reporting asset values on financial statements at fair values gives managers ample opportunity to slant asset values upward to artificially increase profits and their stock prices. Managers may be motivated to alter earnings upward so they can earn bonuses. Despite the risk of manager bias, equity investors and creditors prefer to know the market values of a firm's assets—rather than their historical costs—because current values give them better information to make decisions.
There are commonly three pillars to valuing business entities: comparable company analyses, discounted cash flow analysis, and precedent transaction analysis.
This method estimates the value of an asset based on its expected future cash flows, which are discounted to the present (i.e., the present value). This concept of discounting future money is commonly known as the time value of money. For instance, an asset that matures and pays $1 in one year is worth less than $1 today. The size of the discount is based on an opportunity cost of capital and it is expressed as a percentage or discount rate.
In finance theory, the amount of the opportunity cost is based on a relation between the risk and return of some sort of investment. Classic economic theory maintains that people are rational and averse to risk. They, therefore, need an incentive to accept risk. The incentive in finance comes in the form of higher expected returns after buying a risky asset. In other words, the more risky the investment, the more return investors want from that investment. Using the same example as above, assume the first investment opportunity is a government bond that will pay interest of 5% per year and the principal and interest payments are guaranteed by the government. Alternatively, the second investment opportunity is a bond issued by small company and that bond also pays annual interest of 5%. If given a choice between the two bonds, virtually all investors would buy the government bond rather than the small-firm bond because the first is less risky while paying the same interest rate as the riskier second bond. In this case, an investor has no incentive to buy the riskier second bond. Furthermore, in order to attract capital from investors, the small firm issuing the second bond must pay an interest rate higher than 5% that the government bond pays. Otherwise, no investor is likely to buy that bond and, therefore, the firm will be unable to raise capital. But by offering to pay an interest rate more than 5% the firm gives investors an incentive to buy a riskier bond.
For a valuation using the discounted cash flow method, one first estimates the future cash flows from the investment and then estimates a reasonable discount rate after considering the riskiness of those cash flows and interest rates in the capital markets. Next, one makes a calculation to compute the present value of the future cash flows.
This method determines the value of a firm by observing the prices of similar companies (called "guideline companies") that sold in the market. Those sales could be shares of stock or sales of entire firms. The observed prices serve as valuation benchmarks. From the prices, one calculates price multiples such as the price-to-earnings or price-to-book ratios—one or more of which used to value the firm. For example, the average price-to-earnings multiple of the guideline companies is applied to the subject firm's earnings to estimate its value.
Many price multiples can be calculated. Most are based on a financial statement element such as a firm's earnings (price-to-earnings) or book value (price-to-book value) but multiples can be based on other factors such as price-per-subscriber.
The third-most common method of estimating the value of a company looks to the assets and liabilities of the business. At a minimum, a solvent company could shut down operations, sell off the assets, and pay the creditors. Any cash that would remain establishes a floor value for the company. This method is known as the net asset value or cost method. In general the discounted cash flows of a well-performing company exceed this floor value. Some companies, however, are worth more "dead than alive", like weakly performing companies that own many tangible assets. This method can also be used to value heterogeneous portfolios of investments, as well as nonprofits, for which discounted cash flow analysis is not relevant. The valuation premise normally used is that of an orderly liquidation of the assets, although some valuation scenarios (e.g., purchase price allocation) imply an "in-use" valuation such as depreciated replacement cost new.
An alternative approach to the net asset value method is the excess earnings method. (This method was first described in the U.S. Internal Revenue Service's Appeals and Review Memorandum 34,[ further explanation needed ] and later refined by Revenue Ruling 68-609.) The excess earnings method has the appraiser identify the value of tangible assets, estimate an appropriate return on those tangible assets, and subtract that return from the total return for the business, leaving the "excess" return, which is presumed to come from the intangible assets. An appropriate capitalization rate is applied to the excess return, resulting in the value of those intangible assets. That value is added to the value of the tangible assets and any non-operating assets, and the total is the value estimate for the business as a whole. See Clean surplus accounting, Residual Income Valuation.
In the below cases, depending on context, Real options valuation techniques are also sometimes employed, if not preferred; for further discussion here see Business valuation #Option pricing approaches, Corporate finance #Valuing flexibility.
When valuing "distressed securities", various adjustments are typically made to the valuation result; this would be true whether market-, income-, or asset-based. These adjustments consider
The financial statements here are similarly recast, including adjustments to working capital, deferred capital expenditures, cost of goods sold, Non-recurring professional fees and costs, and certain non-operating income/expense items
In many of these cases, the company in question is valued using real options analysis - see Business valuation #Option pricing approaches. This value serves to complement (or sometimes replace) the above value.
Startup companies such as Uber, which was valued at $50 billion in early 2015, are assigned post-money valuations based on the price at which their most recent investor put money into the company. The price reflects what investors, for the most part venture capital firms, are willing to pay for a share of the firm. They are not listed on any stock market, nor is the valuation based on their assets or profits, but on their potential for success, growth, and eventually, possible profits.Many startup companies use internal growth factors to show their potential growth which may attribute to their valuation. The professional investors who fund startups are experts, but hardly infallible, see Dot-com bubble.
Valuation models can be used to value intangible assets such as for patent valuation, but also in copyrights, software, trade secrets, and customer relationships. Since few sales of benchmark intangible assets can ever be observed, one often values these sorts of assets using either a present value model or estimating the costs to recreate it. Regardless of the method, the process is often time-consuming and costly.
Valuations of intangible assets are often necessary for financial reporting and intellectual property transactions.
Stock markets give indirectly an estimate of a corporation's intangible asset value. It can be reckoned as the difference between its market capitalisation and its book value (by including only hard assets in it).
In mining, valuation is the process of determining the value or worth of a mining property. Mining valuations are sometimes required for IPOs, fairness opinions, litigation, mergers and acquisitions, and shareholder-related matters. In valuation of a mining project or mining property, fair market value is the standard of value to be used.
The CIMVal Standards ("Canadian Institute of Mining, Metallurgy and Petroleum on Valuation of Mineral Properties") are a recognised standard for valuation of mining projects and is also recognised by the Toronto Stock Exchange. The standardsstress the use of the cost approach, market approach, and the income approach, depending on the stage of development of the mining property or project. See also Mineral economics in general, and Mineral resource classification.
In finance, discounted cash flow (DCF) analysis is a method of valuing a project, company, or asset using the concepts of the time value of money. Discounted cash flow analysis is widely used in investment finance, real estate development, corporate financial management and patent valuation. It was used in industry as early as the 1700s or 1800s, widely discussed in financial economics in the 1960s, and became widely used in U.S. Courts in the 1980s and 1990s.
Fundamental analysis, in accounting and finance, is the analysis of a business's financial statements ; health; and competitors and markets. It also considers the overall state of the economy and factors including interest rates, production, earnings, employment, GDP, housing, manufacturing and management. There are two basic approaches that can be used: bottom up analysis and top down analysis. These terms are used to distinguish such analysis from other types of investment analysis, such as quantitative and technical.
Discounting is a financial mechanism in which a debtor obtains the right to delay payments to a creditor, for a defined period of time, in exchange for a charge or fee. Essentially, the party that owes money in the present purchases the right to delay the payment until some future date. The discount, or charge, is the difference between the original amount owed in the present and the amount that has to be paid in the future to settle the debt.
To invest is to allocate money in the expectation of some benefit in the future.
In accounting, equity is the difference between the value of the assets and the value of the liabilities of something owned. It is governed by the following equation:
In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization or impairment costs made against the asset. Traditionally, a company's book value is its total assets minus intangible assets and liabilities. However, in practice, depending on the source of the calculation, book value may variably include goodwill, intangible assets, or both. The value inherent in its workforce, part of the intellectual capital of a company, is always ignored. When intangible assets and goodwill are explicitly excluded, the metric is often specified to be "tangible book value".
In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued are bought, while stocks that are judged overvalued are sold, in the expectation that undervalued stocks will overall rise in value, while overvalued stocks will generally decrease in value.
Rational pricing is the assumption in financial economics that asset prices will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away". This assumption is useful in pricing fixed income securities, particularly bonds, and is fundamental to the pricing of derivative instruments.
Enterprise value (EV), total enterprise value (TEV), or firm value (FV) is an economic measure reflecting the market value of a business. It is a sum of claims by all claimants: creditors and shareholders. Enterprise value is one of the fundamental metrics used in business valuation, financial modeling, accounting, portfolio analysis, and risk analysis.
Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to effect a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest. In some cases, the court would appoint a forensic accountant as the joint expert doing the business valuation.
John Burr Williams was an American economist, recognized as an important figure in the field of fundamental analysis, and for his analysis of stock prices as reflecting their "intrinsic value."
Capital budgeting, and investment appraisal, is the planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure. It is the process of allocating resources for major capital, or investment, expenditures. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.
In economics, valuation using multiples, or “relative valuation”, is a process that consists of:
Intellectual property assets such as patents are the core of many organizations and transactions related to technology. Licenses and assignments of intellectual property rights are common operations in the technology markets, as well as the use of these types of assets as loan security. These uses give rise to the growing importance of financial valuation of intellectual property, since knowing the economic value of patents is a critical factor in order to define their trading conditions.
The following outline is provided as an overview of and topical guide to finance:
The First Chicago Method or Venture Capital Method is a business valuation approach used by venture capital and private equity investors that combines elements of both a multiples-based valuation and a discounted cash flow (DCF) valuation approach.
The Chepakovich valuation model is a specialized discounted cash flow valuation model, originally designed for the valuation of “growth stocks”, and subsequently applied to the valuation of high-tech companies - even those that are (currently) unprofitable. Relatedly, it is a general valuation model and can also be applied to no-growth or negative growth companies. In fact, in the limiting case of no growth in revenues, the model yields similar results to a regular discounted cash flow to equity model. The model was developed by Alexander Chepakovich in 2000 and enhanced in subsequent years.
The clean surplus accounting method provides elements of a forecasting model that yields price as a function of earnings, expected returns, and change in book value. The theory's primary use is to estimate the value of a company’s shares. The secondary use is to estimate the cost of capital, as an alternative to e.g. the CAPM. The "clean surplus" is calculated by not including transactions with shareholders when calculating returns; whereas standard accounting for financial statements requires that the change in book value equal earnings minus dividends.
In finance, a contingent claim is a derivative whose future payoff depends on the value of another “underlying” asset, or more generally, that is dependent on the realization of some uncertain future event. These are so named, since there is only a payoff under certain contingencies. Any derivative instrument that is not a contingent claim is called a forward commitment. The prototypical contingent claim is an option, the right to buy or sell the underlying asset at a specified exercise price by a certain expiration date; whereas (vanilla) swaps, forwards, and futures are forward commitments, since these grant no such optionality. Contingent claims are applied under financial economics in developing models and theory, and in corporate finance as a valuation framework.
Corporate finance is an area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.
There is no meaningful stock market for these shares. Their values are based on what a small handful of investors—usually venture capital firms, private equity firms or other corporations—are willing to pay for a stake.