what is valuation?

Question

what is valuation?

Answer 1

Valuation of a stock is a method by which a "fair price" (or "fair value") is put on that stock. Presumably if you can buy a stock below its fair price it is a good buy. Conversely, a stock trading above its fair price is considered "over valued" and a poor investment.

So how do you value any given stock? Unfortunately the answer is very complex. The are literally dozens of different ways to value stocks. Probably the most widely discussed method is the price-to-earnings ratio, or P/E. That is the price of the stock divided by the underlying company's earnings over the last twelve months. The logic goes that the higher the P/E the more richly valued a stock is. People looking for bargains will sometimes try to find quality companies with stocks whose P/E is in the single digits. During the tech bubble P/E's of individual companies were often 50 and up. During the great bear market of the 70's the avergae P/E for the entire stock market fell below 10. The long term average for the the S&P 500, by the way, is about 12. The problem comes with the quality and sustainability of the "E" in the equation. A company may have had great earnings in the previous year due to roll out of a new product but maybe their pipeline is empty and they will not be able to repeat over the next year. That will drop the "E" and raise the P/E. Another complicating factor is that average P/E's tend to vary widely across industries. Supermarkets that are very slow growing companies with tiny profit margins often have P/E's of 10 or less. Fast growing small-cap tech companies often have P/E's 20 or 30 and above. That is because investors are willing to pay more for current earnings assuming that earnings will accelerate in the future.

Now to really complicate things. Institutional investors and professional traders rarely put much faith in P/E ratios. Instead they tend to use a method called the Discounted Cash Flow model. This model tries to calculate all of the future earnings ("cash flows") or dividends of a company and then state what those earnings are worth in current dollars (basic financial theory: a dollar in your hand today is worth more than a dollar that you are going to receive at some point in the future. That devaluation of future dollars is called "discounting" and is largely based on the rate of inflation and the risk of never getting the money). To make that caclulation you need to make assumptions about the future rate of inflation, the future earnings of the company, how much they will have to pay to borrow working capital, etc.

Basically there are entire books written on valuation and it is a very controversial and complex matter.

Answer 2

In a nutshell valuation is the price at which something is valued. For example if I said XYZ Corp's stock is trading at a very low valuation, I'd really be saying that XYZ trades at a low price relative to what the company is worth.

Answer 3

Valuation is the process of determining the current worth of an asset or a liability or a derivative.

Answer 4

In what context?