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What is a Valuation Method?

Jim B.
Jim B.

A valuation method refers to any one of the various methods used by investors to determine the worth of a company. These methods can be used to compare different companies with similar characteristics to one another, and they can determine current value or estimate value in the future. An investor can choose a valuation method based on statistical formulas which use financial information to derive a conclusion on a company's economic strength. Other methods of valuation are more subjective, such as analysis of company management or long-term marketing strategies.

Investors have practically limitless choices when it comes to the companies seeking to lure their investment capital. Choosing between all of these different companies can be a difficult task. Luckily, there are ways that an investor can break down a company based on financial information. By contrast, other investors may take a more subjective approach, looking at aspects of a company that can't be gleaned from the numbers. No matter what valuation method is used, it should give an investor a good idea of whether the company in question is a worthwhile investment.

Businesswoman talking on a mobile phone
Businesswoman talking on a mobile phone

For a valuation method to be successful, it must provide an accurate appraisal of the overall worth of that company, both at the current time and looking ahead to the future. Financial ratios are very popular valuation methods because they crunch the numbers to provide useful measurements. There are ratios which measure cash flow, debt levels, efficiency, and many other aspects of a company's operations that go a long way toward determining its overall worth.

It is important to realize that using a financial ratio as a valuation method can be problematic when comparing two companies with different characteristics. For example, a ratio measuring a company's ability to pay its debt might be more favorable to an established company than it is to a new company that is using numerous loans to get its business up and running. Investors should try to use context with statistical information to provide the best picture of a company's worth.

If an investor doesn't trust the numbers, he can use a valuation method based more on gut feelings about how a company stands in comparison to its competitors. A company that is struggling financially might not look good on paper, but a management change could signify better things to come. In some cases, current events in the country where the company is located can have a significant impact on its worth. Savvy investors can use these pieces of information to analyze a company apart from anything related to its bottom line.

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