Valuation analysis of a company may be required by investors, in case of business sale, to initiate a public offering process, or by analysts among other stakeholders. So, how does a valuation analysis work and what all aspects does it cover? While it may sound complex and technical, valuation analysis requires a basic and common understanding of a business and the various factors that impact business performance.
Valuation analysis requires comparing the stock market value and financial parameters of a company’s stock to gauge its true worth.
Stock market values include:
Financial parameters included in valuation analysis include:
After financial analysis, valuation analysis acts as a second level check for stock performance.
It helps in estimating whether a company’s stock is trading at appropriate price levels or is overvalued.
After conducting financial analysis to gauge the strength of a company, an analyst can proceed towards conducting valuation analysis, which helps in checking whether the company’s stock is priced correctly.
In case a company’s shares are overvalued, it is best to avoid investing in them. Investing in overvalued stocks can result in high levels of investment risk and lowers the potential of capital appreciation in the future. Valuation analysis is therefore important for taking an investment decision around any company’s stock.
The 3 main valuation analysis techniques that are commonly adopted by investors are:
This method of valuation analysis involves selecting:
The commonly used multiples under this method are:
Asset-based approach, which includes estimating a company’s Net Asset Value (NAV) is one of the easiest valuation techniques.
NAV is:
An analyst must estimate the fair value of assets in this case because the fair value may be substantially different from acquisition value, especially in the case of non-depreciating assets and also the recorded value of depreciating assets.
The fair value of a company’s net assets can be significantly different from the value derived by simply adding the net asset prices. To improve the NAV calculation, analysts may use the Replacement Cost Method, which takes into account the value of assets that any individual who is of the importance of the business may pay for establishing a business exactly the same as the present one. This method helps analysts arrive at the value of a stock.
Under this method, investors mainly use the Discounted Cash Flow (DCF) technique, which involves the calculation of the present value of a company’s future cash flows. Here, discounting is done to arrive at the present value using the company’s cost of capital.
After considering all three methods, an investor may still want to clarify which method to pick? The answer depends on:
It is not necessary for an investor or analyst to use value estimates of a single method at a time. They can use a combination of methods mentioned above and use their average to prepare the final valuation of a company.
No one wants to invest in an overvalued stock that may heighten the risk of capital loss. Hence, before investing in a stock, an investor must conduct a valuation analysis of a company. This will help in understanding the true worth of the stock. Investors often use a combination of fundamental analysis, valuation analysis and ratio analysis to gauge an investment’s worth.
Fundamental analysis is used to value stocks by evaluating their intrinsic or fair value. Technical analysis is also used for stock valuation by evaluating the charts and price trends to predict future stock prices.
Both fundamental and technical analysis are equally important while determining the true worth of a stock and the company. While the technical analysis may mostly help short-term investors, fundamental analysis supports long-term investors in decision-making.
Depending on the technique used, valuation analysis uses a combination of past and present data to derive the true value of a company and assist in decision-making.
Valuation analysis involves the use of quantitative analysis to gauge a company’s true value. Some of the factors used include cash flows, the fair value of assets, and the earnings performance of the company.
Value investing is an investment technique used by investors to identify stocks that are currently trading at prices lower than their intrinsic or true value. This is often used by seasoned investors who possess market know-how and some level of industry expertise to gauge the true value of a company.
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