Valuation can be defined as the process for assessing the present value (PV) of an asset. Valuations can be done on assets (like investments in marketable securities including stocks, options, business enterprises, or intangible assets including patents and trademarks) or even on liabilities (like bonds issued by a company). The process of valuation is very important for investment analysis, capital budgeting, merger and acquisition transactions, and financial reporting.
Models used for financial valuation of assets
Broadly the process of valuation of financial assets uses one or two types of models,
- Absolute value models: This model helps to determine the present value of an asset’s expected future cash flows. Absolute value model takes two general forms namely, multi-period models like discounted cash flow models or single-period models like Gordon model. Note, these kind of models is based on mathematics rather than price observation.
- Relative value models: This model helps to assess value based on the observation of market prices of similar assets.
- Option pricing models: This model is used for certain types of financial assets such as warrants, put options, call options, ESOP’s, investments with embedded options such as a callable bond etc and are considered as complex present value model. One of the most commonly used option pricing models are the Black–Scholes-Merton models and lattice models.
Discounted cash flow method
The Discounted Cash Flow Methods is used to estimate the value of an project, based on its expected future cash flows, which are discounted to the present. Primarily, the concept of discounting future money is referred as time value of money. Remember, the size of the discount is based on an opportunity cost of capital and it is expressed as a percentage or discount rate.
The amount of the opportunity cost depends on a relation between the risk and return of on investment, in finance. According to economic theory people are rational and risk averse therefore, they need incentives to accept risk. Now the incentives can be achieved in the form of higher expected returns after buying a risky asset. Therefore, the more risky the investment, the more return investors want from that investment.
Illustration
Let us assume that the first investment opportunity for investment is a government bond which pays interest of 5% per year and the principal and interest payments are guaranteed by the government. On the other hand, the second investment opportunity is a bond issued by small project which also pays annual interest of 5%. Which bond would an investor choose?
Solution
Given a choice between the two bonds, virtually all investors would buy the government bond rather than the small-project bond as the first is less risky while paying the same interest rate as the riskier second bond. As, an investor has no incentive to buy the riskier second bond.
Therefore, to attract capital from investors, the project issuing the second bond must pay an interest rate higher than 5% that the government bond pays else, no investor is likely to buy that bond thereby the project will be unable to raise capital. Since by offering to pay an interest rate more than 5% the project gives investors an incentive to buy a riskier bond.
The investor performing valuation using the discounted cash flow method, first estimate the future cash flows from the investment and then estimate a reasonable discount rate after considering the riskiness of those cash flows and interest rates in the capital markets. Then make a calculation to compute the present value of the future cash flows.
Guideline companies method
The Guideline companies method helps to determine the value of a project by observing the prices of similar companies (referred as guideline companies) which are sold in the market. This sales could be shares of stock or sales of entire firms. The prices being observed serves as benchmark for valuation. From the observed prices, one can calculate price multiples such as the price-to-earnings or price-to-book ratios whichever is used to value the firm. Note, we can calculate many price multiples most of which are based on a financial statement element such as a firm’s earnings (i.e., price-to-earnings) or book value (i.e., price-to-book value) but multiples can be based on other factors such as price-per-subscriber.
Net asset value method
The net asset value method is one of the most common methods, used to estimate the value by analyzing the assets and liabilities. This method is also known as the net asset value or cost method. Generally, the discounted cash flows of a well-performing project exceed the specified floor value. The Net asset value method is be used for valuing portfolios of investments that are heterogeneous, as well as nonprofits, for which discounted cash flow analysis is not important. The basic premise of valuation generally used is that of an orderly liquidation of the assets, even though some valuation scenarios indicates an “in-use” valuation such as depreciated replacement cost new.
