Approaches to Valuation

Analysts use a wide spectrum of models, ranging from the simple to the sophisticated. These models often make very different assumptions about the fundamentals that determine value, but they do share some common characteristics and can be classified in broader terms. There are several advantages to such a classification -- it makes it is easier to understand where individual models fit in to the big picture, why they provide different results and when they have fundamental errors in logic.

In general terms, there are three approaches to valuation.

1. Discounted cashflow valuation, relates the value of an asset to the present value of expected future cashflows on that asset. 

2. Relative valuation, estimates the value of an asset by looking at the pricing of 'comparable' assets relative to a common variable like earnings, cashflows, book value or sales.

3. Contingent claim valuation, uses option pricing models to measure the value of assets that share option characteristics.

While different methods can yield different estimates of value, one of the objectives of discussing valuation models is to explain the reasons for such differences, and to help in picking the right model to use for a specific task.