Valuation (finance)
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Valuation is the process of "estimating" the value of an asset or liability. The value is the price of the asset or liability times the quantity held. Valuations are required in many contexts including all industries, finance, property management and the antiques industry.
Generally speaking in advanced economies the valuation rests on some estimate of current price or estimated fair market price now rather than the book value or the book price (the latter being the acquisition cost of the asset or liability, or the depreciated book value, rather than its value now).
In the financial industry, valuations are required for financial assets or liabilities for various reasons including tax, regulatory and accounting (including reporting to owners and stakeholders). The valuations are as of a specific date e.g., the end of the accounting quarter or year. They may alternatively be mark-to-market (estimates of the current value of assets {liabilities} as of this minute or this day) for the purposes of managing portfolios and associated financial risk (e.g., within large financial firms including investment banks and stockbrokers).
Some balance sheet items are much easier to value than others. Publicly traded stocks and bonds have prices that are quoted frequently and readily available. Other assets are hard to value since, for instance, private firms that have no frequently quoted price. Additionally financial instruments that have prices that are partly dependent on theoretical models of one kind or another are difficult to value. For example, options are generally valued using the Black-Scholes model while the liabilities of life assurance firms are valued using the theory of present value.
It is possible and conventional for financial professionals to make their own estimates of the valuations of assets (liabilities) that they are interested in, and their calculations are of various kinds including analyses of companies that focus on price-to-book, price-to-earnings, price-to-cashflow and present value calculations, and analyses of bonds that focuses on credit ratings (e.g. assessments of default risk), risk premia and levels of real interest rates. All of these approaches may be thought of as creating estimates of value that compete for credibility with the prevailing share or bond prices (where applicable) and may or may not result in buying or selling by market participants.
It is very important to note that valuation is more an art than a science:
1) There are very different situations and purposes in which you value an asset (e.g. company in distress, tax purposes, mergers & acquisitions, quarterly reporting). In turn this requires different methods or a different interpretation of the same method each time.
2) All valuation models and methods have their limitations (e.g., mathematical, complexity, simplicity, comparability) and could be widely criticized. As a general rule the valuation models are most useful when you use the same valuation method as the "partner" you are interacting with. Mostly the method used is industry or purpose specific;
3) In all valuation models there are a great number of assumptions that need to be made and things might not turn out the way you expect. Your best way out of that is to be able to explain and stand for each assumption you make;
4) If feasible, the valuation where there are a lot of intangibles is linked to an interaction process with a potential "partner" . The main intangible is demand and supply. Preparation and negotiation strategy is others. To have alternative partners is a third.
When a valuation is prepared all assumptions should be clearly stated, especially the context. It is improper, for example, to value a going concern, based on an assumption that it is going out of business, since then only a salvage value remains.
Asset pricing models
See also Modern portfolio theory
- Capital asset pricing model (CAPM)
- Arbitrage pricing theory (APT)
- Intertemporal CAPM (ICAPM)
- Consumption based CAPM (CCAPM)
- Black-Scholes (for Options)
Valuation of Intellectual Property