Overview
Valuation is the process of calculating a theoretical (model based) value for a firm. This value is in contrast to the market value of the firm (if it is publicly traded) which can be computed simply by multiplying the market price of the firms shares by the number of shares outstanding.
The theoretical value of a firm can be useful in the following situations:
- The company may be private, so that no market value is available. For buyers of private firms, a theoretical value needs to be computed.
- Theoretical values can point to mispricings in the market value of the firm which can lead to trading opportunities
- The management wants to understand the drivers of value, in order to take actions to increase. A model may be helpful in elaborating where the value of the firm comes from.
Valuation in Theory
Microeconomic Theory provides a context by which to understand what valuation is and how it should be understood.
- Merton Model - equity as an option on the company's assets
- Valuation and Capital Structure
Valuation Techniques
Valuation is not an exact science. Various tools have been developed to try to approximate an answer.
- Discounted Cash Flow is a technique based on a present value analysis of a companies earnings or cash flows.
- Relative Valuation does not seek to build a valuation from the asset fundamentals, but by comparing to assets of a similar type and quality.
- Arbitrage Free Valuation looks to calculate a fair value for an asset based on the assumption that arbitrage does not exist in the market.
Valuation Techniques by Firm Type
Some firms, primarily financial firms, are difficult to value by the standard techniques listed above. The following represent alternative methods to tackle the specific challenges related to these types of firms.