The Importance of Valuation

by Andrew McGuinness     lip 16, 2019

Valuation, if you are not yet aware, is the method used to establish the value of any particular asset or company. When determining value, an analyst will look at a number of criteria. What is important to consider during this valuation process is the way a company is being managed, the design of its capital structure, assumed future profits, and the current value of its assets on the market.

Now that you’re aware of what valuation is, as well as what goes into the analysis and determination of value, let’s get into why exactly valuation is important. The following are 4 reasons why valuation is a process that should be taken very seriously.

1. For the individual investor

As an individual, you are able to use valuation methods in order to predict the value of businesses and assets on your own. Upon receiving this information, the stock market is able to consider what effect this will have on the corresponding stock price. Of course, at an individual level, many distinct results will arise and stock prices may differ greatly from one person to another. If an investor is able to distinguish the difference between the market value of a business and its intrinsic or true value, however, they may earn a considerable sum of money.

2. For the market

The valuation of businesses allows them to be valued accordingly within the stock market. This means if, according to valuation methods, a business is relatively stable and shows a substantial amount of promise, it will raise in value on the market. This is because the market receives information concerning valuation of businesses and assets and then adjusts the status of these in real time. Valuation therefore allows companies to earn their stances and take advantage of their rightful positions in the market.

3. Methodology

The fact that there is more than one valuation method that you are able to choose from is already a good sign. There is no one way to analyse and calculate value, this is a given. For this reason, different techniques for the determination of valuation are available for employment.

Two of the most well-known methods are discounted cash flow (DCF) and the market multiple method. The DCF method focuses on future earnings of a business. The method accomplishes this by attempting, to the best of its ability, to fairly accurately assess the future cash flow a company may yield. The discounted cash flow method does so by closely analysing present value and risk-adjusted return.

The market multiple method puts a slightly different technique into play. Rather than focusing on future cash flows, this method looks at how sales price compares to other significant financial criteria that will put this price into perspective. These criteria include earnings, revenue, and debt.

While the discounted cash flow is able to describe your business history and the direction in which the future is taking it, it is obviously difficult to assess the future accurately. There is no guarantee with the discounted cash flow method, no matter how well the criteria involved has been researched and analysed, and how carefully everything has been calculated.

When considering the market multiple method, however, it is much easier to trust that the techniques applied will give you an accurate estimation of what investors are spending in the purchase of a business. Despite the fact it does not consider other unique qualities of businesses, it is often a safer bet than the DCF method.

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