In finance, investing, and business in general, valuation is a key skill. Markets set prices, but applying an accurate valuation to assets being priced in that market can provide insight into how accurate that market pricing is. However, all valuations are biased and based on many assumptions. Therefore, valuation is less of a precise method to determine the “correct” price, but rather more of an art that is a useful tool for evaluating an asset. Valuation models can be very quantitative and complex, but more quantitative models are not always better. Frequently, the simplest valuation method is the best.

There are three cental forms of valuation:
1. Discounted Cash Flow (DCF) - in very general terms the DCF assumes the value of an asset is the present value of all of the asset’s future cash flows.

2. Comparable Companies Analysis (Relative Valuation) - this method values an asset by comparing the asset to the value of other similar assets. This method is used most frequently.

3. Option Pricing Valuation - this form applies option pricing models to measure the value of assets with real option characteristics. This does not work for every company. The method is only applicable to about 20% of companies.

Individuals’ careers, goals, and other factors help determine which valuation approach is best. In addition, by using multiple valuations methods to price an asset, investors can generate a range of values. Valuation also has a unique element in that there is often immediate feedback on valuation results. Most assets have a market price that valuations can be compared to.

Most valuations are not for public companies, but for smaller private businesses. The primarily reasons for these private valuations are taxes and divorce. When small businesses are sold or transferred a valuation needs to be determined for tax purposes. During a divorce, a value needs to be determined to properly divide the assets.

This introduction to valuation and future posts about the subject are primarily based on NYU Professor Damodaran’s Equity Instruments course.

Comparable Company Analysis Overview

Fat Tails and Limitations of Normal Distirbutions

Introduction to Financial Derivatives

GSTrUE: Goldman Sachs’s Tradable Unregistered Equity OTC Market

Monkey Business - Investing Lessons from the Investment Banking World