Valuation methods determine the value of a company’s assets and liabilities. These methods are typically based on the assumptions used in various accounting frameworks, such as Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).

When creating financial models, it is important to understand the impact of different accounting and valuation methodologies. Accounting rules have a significant influence on financial models, as they affect how the company’s financial statements are prepared. Similarly, different valuation techniques can have a major impact on model results.

For example, when valuing a company’s assets, the choice of method can have significant consequences. The same asset may be valued differently when using different accounting treatments, such as the cost or fair value method. Let’s discuss this in detail.

What Are Valuation Methods?

In financial analysis, valuation methods can be based on either historical costs or current market prices. For example, the cost method values an asset at its original purchase price, while the fair value method considers any changes in the market price of the asset since its purchase.

Depending upon the type of asset being valued and the accounting framework used, both methods may be applicable. For example, when using Generally Accepted Accounting Principles (GAAP) in the U.S., there are specific rules for determining which method should be used.

Some common valuation methods used by businesses include:

• Discounted Cash Flow (DCF) Analysis: A DCF analysis calculates the present value of an asset by discounting future cash flows based on the asset’s risk and required rate of return.
• Comparable Company Analysis: It compares a company’s valuation multiples (such as price to earnings, price to book value, or enterprise value to EBITDA) with those of similar companies in the same industry.
• Relative Valuation: Relative valuation compares a company’s estimated value to its actual market price and then adjusts for differences.
• Asset-Based Valuation: Asset-based valuation looks at the underlying asset values of a business and then applies an appropriate multiple or rate to determine the total value.
• Option Pricing Model (OPM): OPM is a mathematical model that values options and other derivatives by analyzing the probability of different outcomes.

What Are Accounting Methods?

An accounting method is a specific process that decides when and how revenue and expenses should be reported. Examples of accounting methods include:

• Cash Method: This method recognizes revenues and expenses when cash or its equivalent is received or paid out.
• Accrual Method: In this method, revenues and expenses are reported when they’re earned or incurred rather than when cash is received or paid.
• Hybrid Method: This method combines elements of both the cash and accrual methods.

Regardless of the accounting method used, organizations must adhere to Generally Accepted Accounting Principles (GAAP). These principles provide a consistent set of guidelines for financial reporting.

When an organization reports its finances, independent auditors may review the information to ensure the accuracy and reliability of the reported data. The process is called an audit.

How Do Accounting Methods Affect Financial Models?

To understand the impact of accounting methods on financial models, it is important to know about the components of a financial model. The following components are affected by accounting methods:

• Revenue Recognition: Accounting methods determine when and how much revenue is recognized in the financial model. Some accounting methods require that all revenue be recognized in the financial model when earned, while others allow for the deferral of revenue recognition.
• Income Tax Expense: The method you select impacts the amount of income taxes to be reported in a financial model. Different accounting methods have different rules regarding the recognition and treatment of income taxes, affecting the amount of income taxes to be reported in a financial model.
• Depreciation/Amortization: Accounting methods also affect the timing and method of depreciation or amortization to be reported in a financial model. For instance, accrual accounting requires that the depreciable amount be recorded in the financial model, regardless of when cash payments are made.

How Do Valuation Methods Affect Financial Models?

Depending on the valuation method used, the results of a financial model may vary significantly. Valuation methods are used to project the value of a company by estimating future cash flows and/or earnings. The two most commonly used methods are the discounted cash flow (DCF) method and the relative valuation method.

Let’s explain how their use will make the resulting financial models different from each other. A financial model built on DCF will emphasize the company’s ability to generate future cash flows, while a relative valuation model will focus on the comparison of similar businesses to determine a company’s value.

Suppose other companies in the industry have an average price-to-earnings ratio of 10, but the company being analyzed only has a P/E ratio of 8. The relative valuation model would suggest that the company’s stock is undervalued.

Meanwhile, the DCF method would require that projected cash flows are discounted to determine the company’s present value. If the projections used in this method were high, then the DCF model would be more optimistic than the relative valuation model.

How to Choose a Valuation Method for Financial Models?

The choice of the valuation method for a financial model should depend on the purpose of the analysis. Relative valuation methods are best when comparing multiple companies, while DCF methods are best when trying to estimate a company’s intrinsic value.

Other considerations include:

• Availability of data
• Degree of precision required
• Time frame for the analysis

In addition to the above considerations, it is important to ensure that whatever method is chosen is appropriate for the type of asset being valued. For example, real estate valuation typically requires different methods than stock or debt valuations.

Let the Professionals Handle It

At Numberly, we can put together investor pitch-ready financial models for startups and entrepreneurs. We work closely with our clients to ensure that the models we create are tailored to their specific needs and goals. As for the valuation method, we use DCF to gauge the inherent value of a company accurately.

Schedule a call with us to learn more.