VALUATION
In finance, valuation is the process of estimating the potential market value of a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., Bonds issued by a company). Valuations are required in many contexts including investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.
VALUATION OVERVIEW
Common terms for the value of an asset or liability are fair market value, fair value, and intrinsic value. The meanings of these terms differ. The most common term in use is probably fair market value defined as the cash price an item would sell for between a willing buyer and willing seller assuming they both have knowledge of the relevant facts and they have no compulsion to buy or sell. Fair value is used in different contexts and has multiple meanings. Some people use the term to mean the same thing as fair market value. Furthermore, in valuation, fair value is also used in accounting and law. In accounting, the term is used as part of generally accepted accounting principles (GAAP) in financial reporting. In law, fair value is often used in state statutes for shareholder rights. In both cases, fair value is defined in the accounting literature or the law, respectively. Fair value in the accounting and legal contexts may be different from each other and may also be different from fair market value. Another term--intrinsic value--is the "true" value of an asset regardless of the asset's market price. For instance, when an analyst believes a stock's intrinsic value is greater than its market price, the analyst makes a "buy" recommendation and vice versa. Moreover, an asset's intrinsic value may be subject to personal opinion and vary among analysts.
BUSINESS VALUATION
Valuation of businesses or fractional interests in businesses may be valued for various purposes such as mergers and acquisitions, sale of securities, and taxable events. An accurate valuation of privately owned companies largely depends on the reliability of the firm's historic financial information. Public company financial statements are audited by Certified Public Accountants (US), Chartered Certified Accountants (ACCA) or Chartered Accountants (UK and Canada) and overseen by a government regulator. Alternatively, private firms do not have government oversight--unless operating in a regulated industry--and are usually not required to have their financial statements audited. Moreover, managers of private firms often prepare their financial statements to minimize profits and, therefore, taxes. Alternatively, managers of public firms tend to want higher profits to increase their stock price. Therefore, a firm's historic financial information may not be accurate and can lead to overvaluation and undervaluation. In an acquisition, a buyer often performs due diligence to verify the seller's information.
FINANCIAL STATEMENT ANALYSIS AND VALUATION
Financial statements prepared in accordance with generally accepted accounting principles (GAAP) often show the values of assets at their historic costs rather than at their current market values. For instance, a firm's balance sheet will usually show the value of land it owns at what the firm paid for it rather than at its current market value. But under GAAP requirements, a firm must show the values of some types of assets--securities held for sale, for instance--at their market values rather than at cost. When a firm is required to show some of its assets at market value, some call this process "mark-to-market." But reporting asset values on financial statements at market values gives managers ample opportunity to slant asset values upward--to artificially increase profits and stock prices. Managers may be motivated to alter earnings upward so they can earn bonuses. Despite the risk of manager bias, investors and creditors prefer to know the market values of a firm's assets--rather than their costs--because the current values give them better information to make decisions. This is why valuation is the most fundamental aspect of any financial transaction.
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