What Is Valuation? Definition and Why It Matter in Finance

Investing
Updated: 17th Sep 2021
Written by Andrew
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Investing
September 17, 2021
Written by Andrew

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In finance, like in life, it’s often the simplest questions that are the trickiest to answer. For instance, what could be easier than figuring out how much something is worth?

If you want to know why that question is so hard to answer, here’s another one: how much would you pay for a gold mine?

Well, first, you’d have to know how much gold it holds. Then, you’d need to know what it will cost to mine, and what the market price of gold is (and will be), and…

Pretty soon, you find yourself knee-deep in new questions that you need to answer before you answer the first. The process of answering these questions – which isn’t quite a science nor an art – is valuation.

What is Valuation?

Valuation is the process of determining the value of an item, entity, or asset through analysis. While there are many ways to go about valuation, all seek to determine a fair price for a particular asset to help customers, investors, and sellers make informed decisions.

One way to think about valuation is to determine how much you should pay for something rather than how much you will pay for it.

In other words, analysts use formulas and systems to determine an asset’s actual value, not the price the market has set.

Understanding Valuation in Finance

You can apply valuation to any item of value, from paintings and diamonds to cars, homes, and businesses.

The process is relatively simple for objects: the value usually comes out to some combination of market price, consideration of its future price, and utility to the owner.

Typically, you use an amalgam of simple math, educated guesses, and a dash of subjectivity, but the final answer is (usually) straightforward.

When it comes to discovering the value of a company, the process gets complex quickly. But because investing can greatly impact our financial futures, the answer here matters more than deciding between burgers and steak for date night.

That’s why analysts and economists provide swarms of methods for determining the answer – each hotly contested with its own area of application.

Types of Valuation Methods

You can divide valuation into two broad categories.

One is relative valuation, wherein analysts measure the value of a company against other companies.

The goal is to show which investment will generate greater yield relative to the competition. As this measure is relatively simple – if far from foolproof – investor valuation often begins here.

Trickier is finding absolute valuation, which seeks to use fundamentals to decide the true value of a company in a vacuum.

Since it’s more complex, analysts usually resort to one of three types of valuation methods, each of which examines the question from a different angle.

But before we go on, note that the methods below require a fair amount of math that we’re not going to get into here.

Instead, we’ll provide a basic explanation so that if you encounter them, you’ll have a notion of what they’re talking about.

Discounted Cash Flow (DCF)

One way to examine a company’s valuation is to look at how much money enters and exists, or what’s known as cash flow.

Since the question is how much the company is worth to you to buy, that cash flow is then discounted by what interest rate – or return on investment – you could reasonably expect to find elsewhere, so you can compare the asset to your other options.

Dividend Discount Model (DDM)

Another valuation focuses on dividends – the payouts some companies provide to shareholders.

In this model, you condense future returns from said dividends to a single number. Then, you compare that number to the price of one share that would pay those dividends to an investor.

Capital Asset Pricing Model (CAPM)

An easy trap to fall into when investing is counting your unhatched chickens; in other words, assuming a rosy outcome and tallying up your gains if everything goes just right. CAPM tackles this problem by making investment risk key to the valuation process.

But while assuming risk is a noble goal, it’s also worth saying that deciding what number to plugin for risk also requires some assumptions.

As such, investors who prefer the CAPM model should bear in mind that this method of valuation relies on predictions and educated guesses – not just facts.

How Earnings Affect Valuation

As an investor, the valuation method you’re most likely to encounter is P/E or the price-to-earnings ratio. Fortunately, calculating P/E is simple.

First, you take the price of one share of a company’s stock. Then, you divide it by EPS, or earnings per share, which is the company’s earnings divided by the number of outstanding common shares.

When looking at P/E, it’s important to note three things:

  • A low P/E may indicate a low share price relative to earnings, suggesting a possible bargain buy
  • A high P/E suggests a high – and possibly overvalued – share price compared to earnings
  • “Low” and “high” are relative to the company’s industry and sector

The point of a P/E ratio is to show whether a company is making more (or less) money than the share price would lead you to expect. It’s also the most prominent way to factor earnings into valuation.

Valuation Methods

The main takeaway from these valuation methods is that it’s difficult – but important. Of course, some methods are better suited for certain situations, but all require you to prioritize and assume specifics about the company in question.

But there’s a reason so many analysts and experts have struggled to find the ideal valuation method: cracking the code means you’d never make a poor investing decision again.

Significance of Valuation

When you learn that you can do something a dozen ways, you might assume that no one has found the “right” way.

And while that’s true with valuation, that doesn’t mean you can’t gain powerful insights from (and thus make better decisions for) the process.

Think of it this way: the perfect business deal just might be paying a couple bucks for a dung heap because you know it’s full of diamonds.

The goal of valuation is to know what the market doesn’t know yet – to show you through analysis which heaps are stuffed with diamonds, and which are just dung…before you put money down and pick up a shovel.

Valuation Definition FAQs

Why is valuation important in finance?

Valuation helps investors and buyers make good decisions by evaluating the worth of a company (and its stock). While several methods exist to find valuation, all seek to make buying, lending, and investing more than a guessing game.

What does the valuation of a company mean?

A company’s valuation is an educated guess (based in mathematics and analysis) on how much a company is worth.

What are the three methods of valuation?

There are dozens of ways to evaluate a company’s worth, such as by examining a company in a vacuum or comparing two businesses. But three of the most common are the dividend discount model (DDM), discounted cash flow model (DCF), and capital asset pricing model (CAPM).

Bottom Line: Valuation Definition

The valuation process is about moving past what the market – and your gut – says and using disciplined analysis.

While the methods are varied, complex, and imperfect, each illuminates some aspect of an asset’s worth.

Ultimately, information is power, and valuation is just another way to get that knowledge.

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Andrew
Andrew
Andrew is an editor-writer living and working in Southern California. While he’s previously focused on editing for financial publications, he’s now dabbling in the writing pool as well. Hobbies include listening to podcasts, and learning about all things financial. (Just don't ask him about logarithms.)