What is Valuation?

Valuation is analyzing a firm's or assets' value to its present value. It can be performed on the assets and liabilities of the firm. 

Business valuation of a firm required for merger and acquisition, capital budgeting, investment analysis, and financial reporting.

There are several methods for computing valuation in an accounting year. The analysts who do the valuation look at the various concepts such as the structure of the capital, the forecast of earnings in the future period, and the price of the market of the asset and along with other metrics. 

Financial statements of an accounting year which are prepared in advance may have historic cost rather than current market value for example the value of land owned by the firm may have some price at which it was purchased. The firms’ financial statements or balance sheet may have recorded the prize at which it was purchased and not on the current value when the company wants to show the fair market value of the land this process is called valuation.

Corporate valuation: Since the primary objective of a business enterprise is to maximize the value of the firm, an efficient tool is required to estimate the effects of alternative strategies on firms’ value. This is called corporate valuation. There are various models for calculating corporate valuation. The business valuation takes the help of various tools such as financial statements, cash flows, financial projections, present value, and cost of capital.

When we are determining the security’s fair value, valuation turns out to be useful. Determining the fair value means that the assumption willingness of both the parties to enter into the transaction i.e., at what price the wiliness to pay by the buyer to the trader. The price in the market or bond value in preference to stock is determined by the purchasers and the traders when security gets traded on the exchange. 

Methods of Valuation/ Business Valuation Method

There are several types of business valuation methods that help an entity to recognize the true value of the firms’ assets, investments, and business.

Market Capitalization: market capitalization involves comparing a firm’s market value with the other in the market. It is one of the subjective methods of valuation. It is the aggregate value of the company based on the current share price and outstanding stocks. It helps the investor to determine the risk and returns involved in the share and helps to make the decision on the sale and purchase of the share. Market capitalization helps to calculate the current market value. 

The formula for calculating market capitalization for shares = market price of share/number of shares. 

Times Revenue Method: Times Revenue Method is used to determine the maximum value of a company in an accounting year. It depends on the industry, local business, and economical environment. It is meant to generate a range of value for a business. 

Discounted cash flow method: Discounted cash flow (DCF) method estimates the value of an asset based on its expected future cash flows. This is discounted to the present value this concept is also known as the time value of money. the size of the discount is based on the opportunity cost of capital.

The formula for calculating the value of the firm in discounted cash flow (DCF) valuation is as follows: 

Value of the firm in a business = Present value of cash flow during an explicit forecast period + Present value of cash flow after the explicit forecast period

During the explicit forecast period- which is often a period of five to fifteen years- the firm is expected to evolve rather rapidly and hence a great deal of effort is expended to forecast its cash flow on an annual basis. The firm is expected to reach a steady state at the end of the explicit forecast period and hence a simplified procedure is used to estimate its continuing value.

The discounted cash flow approach to valuation involves 5 steps: 

  1. Analyzing historical performance
  2. Forecasting cash flows 
  3. Establishing the cost of capital
  4. Determining the continuing value at the end of the explicit forecast period 
  5. Calculating the firm value and interpreting results

Book value: This is the simplest method and is based on the information found on the balance sheet. Book value is the value of an asset that is described in the financial statement of the company. Book value can also be called as the net asset value because it is calculated by subtracting the intangible assets and liabilities from the total assets. It is equivalent to the carrying value on the balance sheet. The accuracy of the book value approach depends on how well the net book values of assets reflect the fair market value.

Valuation Concept 

Liquidation value versus going concern value: An amount that can be realized when an asset or a group of assets representing a part or even the whole firm, is sold separately from the operating organization to which it belongs, is termed as the liquidation value. The going concern value is the amount that is realized if the firm is sold as a continuing operating entity.

Security valuation models assume a going concern in which an operating business entity generates cash flows through its security holders. When going concern assumption is not appropriate as in the case of impending bankruptcy, the Liquidation value of the asset is more relevant in determining the firm’s financial securities.

Book value versus market value: The book value of an asset is the accounting value of the asset which is simply the historical cost of the asset less accumulated depreciation the book value of the firm’s equity = The book value of the asset – Book value of liabilities.

The market value of an asset is the market price at which the asset trades in the market. Many times market value is greater than the book value.

Market value versus Intrinsic value: The price at which the security currently trades in the financial market is termed the market value of the security. However, the intrinsic value of a security is the present value of the cash flow stream expected from the security, discounted at a rate of return appropriate for the risk associated with the security. Intrinsic value is the economic value. If the market is reasonably well-organized, the market price of a security should float around its intrinsic value. 

Determine the continuing value: It is based on the several methods 

  1. Price to be Price before interest and tax method: the expected PBIT that is the price before interest and tax is the first year after the explicit forecast period
  2. Market to book ratio method: according to this method, the continuing value of the is assumed to be some multiple of its book value at the end of the year.

Context and Applications    

This topic is significant in the professional exams for both undergraduate and graduate courses, especially for  

  • B.B.A. 
  • M.B.A. 
  • B.Com

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