What Is Valuation?
The purpose of valuation is to appraise a security and compare the calculated value to the current market price in order to find attractive investment candidates.
While the current market price is said to reflect all variables (including irrational behavior), valuation models will only factor in a few variablesâ€”this is why there are so many different methods of valuation.
Outside of the essential valuation meaning, it is related to fundamental analysis which attempts to analyze the “fundamental drivers”of a business.
To arrive at a valuation, fundamental analysis looks at a broad spectrum of driving factors such as internal financial metrics like earnings and future obligations, as well as the external environment such as the federal interest rate.
This stands in contrast with technical analysis, which analyzes statistical trends of trading activity displayed on charts, such as changes in price and volume.
What is Valuation of a Company
Among the many methods, three of the most common models for determining the value of a company or asset are the following:
There are two categories of valuation:
1.) Absolute valuation considers company fundamentals like dividends and cash flow to establish the intrinsic value of a company.
DDM, DCF, and CAPM are all models that strive to calculate absolute valuation.
2.) Relative valuation compares a company with other similar companies to determine a relative value.
Analysts compare metrics, like the P/E multiple, to determine whether a company is potentially more attractive than its competitors.
This method of valuation is usually easier than absolute valuation, so analysts and investors often start with relative valuation first.