The process of determining the value of an asset or company is called valuation. Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions; financial reporting, taxable events to determine the proper tax liability, and in litigation.
Valuation concepts, whether for stocks and bonds or for complex derivatives, are important in financial management. The importance of valuation is:
(1) Portfolio management – The role of valuation in portfolio management is determining in large part by the investment philosophy of the investor. Valuation plays a minimum role in portfolio management for a passive investor, whereas it plays a large role for a passive investor, whereas it plays a larger role for an active investor. Even among active investor, the nature and role of valuation are different for different types of active investment.
(2) Valuation in acquisition analysis – valuation should play a central part of acquisition analysis. The bidding firm or individuals have to decide on a fair value for the target firm before making a bid, and the target firm has to determine a reasonable value for itself before deciding to accept or reject the offer.
(3) A value in corporate finance – There is a role of valuation at every stage of a firm’s life cycle. For small private businesses thinking about expanding, valuation plays a key role when they approach to venture capital and private equity investors for more capital. The share of a firm that a venture capitalist will determine in exchange for a capital infusion will depend upon the value she estimates for the firm. As the companies get larger and decide to go public, valuations determine the price at which they are offered to the market in public offering.
(4) Valuation for legal and tax purpose – Most valuations, especially of private companies are done for tax and legal reasons. A partnership has to be valued, whenever a new partner is taken on or an old retires, and businesses that are jointly owned have to be valued when the owner owners decide to break up. Business has to be valued for estate tax purposes when the owner dies and for divorce proceedings when couples break up.