What 'valuation' is, and why it's worth knowing about

Alice discusses valuation, exploring its applications in investment banking and life in general

If there is one subject that every student preparing to interview for investment banking needs to master, it is valuation. Or, put another way, the means of developing an opinion on what something is worth. Why is it so important and what is it all about?

Everyone gets involved in a valuation at some point in their lives. Buying a house? You will want a clear idea of what it is worth, because you will not want to pay more than it is really worth. Selling your car? Again, you will want to form an accurate view of its value, because you will not want to sell it for less. Buying some second hand books from a student in the year above you and negotiating a price? Yet again, you are involved in valuation and to do a deal you will have to reach a consensus valuation with the seller.

In fact, every time you buy or sell something, you form a view and act on your opinion of fair value. How do you form this view?

For most things, there are markets that provide transparent prices. Retailers publish their prices, and keen competition between them means that consumers can usually be confident of paying fair 'market' prices. As a result, there is usually little difference between the prices charged for the same goods by different retailers. In highly advanced markets, sellers tend to exchange goods directly with buyers, with no intermediary (or middleman) involved.

In less "liquid" markets (i.e. markets where there is not a lot of trading activity), intermediaries can make money by connecting buyers with sellers, and giving their opinion on fair value. In the housing market, if you want to get a view of market prices, you can compare them in estate agents' windows. (Prices derived in this way are termed "Comparables"). And if you want to see what recent prices have been for actual house sales, you can look them up at the Land Registry. (These are known as "Precedents"). However, if you want a specific opinion on the value of your house, you ask an estate agent or a chartered surveyor for their opinion.

With a little investigative effort or professional advice, it is usually easy to find out the market value of any asset. But you do not necessarily have to agree with that value. Life gets interesting if you feel a market is undervaluing or overvaluing an asset at a particular point in time. If you have a different opinion to the market, you take the view that there is a disparity between the true value (or fundamental value) of the asset, and the prevailing market value. Either position creates a buying or selling opportunity, if you believe the market will come round to your point of view at some time in the future.

In the corporate world, for any company whose shares are quoted on a stock exchange, there is a market that continuously provides a clear value of its equity. The stock exchange rules include the requirement that at least one stockbroker quotes "buy prices" and "sell prices" in that company at all times. The stock exchange then publishes the average of the price quotations of these so-called market makers, and it is these consensus prices that also get published in newspapers each day.

However, just as with all other assets, the stock market only quotes a consensus of current prices. Everyone involved in investing in companies questions whether the market value is the true value of a company. It is investment bankers whose single most important function is to form an opinion on a company's true value. They provide this opinion to the company's directors, its current shareholders, its creditors and prospective investors - in fact anyone who has a stake in the company, or might want one in the future.

How do investment bankers form this opinion? They chiefly employ two methodologies. The first method may be described as Fundamental Valuation and this tends to involve a Discounted Cashflow (or "DCF"). The second may be termed Relative Valuation.

There is seldom complete agreement on valuation, by principals or their advisers, and it is this very lack of consensus that creates price disparities which buyers and sellers act on in the hope that their opinions are proved right, and in so doing, they gain value and make money.