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What is a 'Valuation'
Valuation is the process of determining the current worth of an asset or a company; there are many techniques used to determine value. An analyst placing a value on a company looks at the company's management, the composition of its capital structure, the prospect of future earnings and market value of assets.
The market value of a security is determined by what a buyer is willing to pay a seller, assuming both parties enter the transaction willingly. When a security trades on an exchange, buyers and sellers determine the market value of a stock or bond. The concept of intrinsic value, however, refers to the perceived value of a security based on future earnings or some other company attribute unrelated to the market price of a security.
How Earnings Impact Valuation
The earnings per share (EPS) formula is stated as earnings available to common shareholders divided by number of common stock shares outstanding. EPS is an indicator of company profit because the more earnings a company can generate per share, the more valuable each share is to investors. Analysts also use the price-to-earnings (P/E) ratio for stock valuation, which is calculated as market price per share divided by EPS. The P/E ratio calculates how expensive a stock price is relative to the earnings produced per share. For example, if the P/E ratio of a stock is 20 times earnings, an analyst compares that P/E ratio to other companies in the same industry and to the ratio for the broader market.
Factoring in Stock Options
Intrinsic value is also used to assess stock options. Assume an investor buys a $50, or strike price, call option on XYZ common stock. The investor has the right to exercise the option and buy 100 shares of XYZ stock at $50 per share before the option expiration date. Intrinsic value is the difference between the current market price of the stock and the option’s strike price. If the current market value is $65 per share, the intrinsic value is $65 - $50, or $15 per share.
Examples of Discounted Cash Flows
Analysts also place a value on an asset or investment using the cash inflows and outflows generated by the asset. These cash flows are discounted into a current value using a discount rate, which is an assumption about interest rates or a minimum rate of return assumed by the investor. If a company is buying a piece of machinery, the firm analyzes the cash outflow for the purchase and the additional cash inflows generated by the new asset. All of the cash flows are discounted to a present value, and the business determines the net present value (NPV). If the NPV is a positive number, the company should make the investment and buy the asset.