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A valuation analysis is a process involving the comparison of the value of one asset to the value of a different asset. In terms of investing, this usually takes the form of assessing the value of one security with the value of a similar security. This activity may also be used to evaluate groups of securities or even compare the current value of an asset with its value at some point in the past.
The goal of valuation analysis is to properly assess the data on hand and determine if a particular asset is worth a sufficient amount to merit acquiring that investment. When used as part of the overall process for determining the wisdom of investing in a given security, a valuation analysis can yield valuable clues regarding the likely future movement of the asset. The analysis can make it clear whether that movement will result in a return that is attractive to the investor, or whether the asset will experience some period of reduction in value. From this perspective, a proper valuation analysis will help the investor decide if he or she should purchase the asset, or abandon the idea and look for more lucrative investments.
Ideally, the valuation analysis is based on a sound metric, such as the price-earnings ratio, or the P/E ratio. This is simply the current price of the stock divided by the earnings generated by the security. Another common foundation for the analysis is the price-to-book ratio, or P/B ratio. Here, the focus is on comparing the book value of the company that issues the security with the current market price of the stock. In order for the analysis to produce viable results, using the same metric all the way through the process is essential.
The core question that governs any valuation analysis has to do with the present worth of the asset. This serves as the starting place for deciding if the investment is viable. In situations where the asset has demonstrated little to no growth in the past, and the general market conditions are anticipated to remain the same in the near future, the investor may see little reason to acquire the investment. On the other hand, if a small but steady increase in value is supported by historical evidence, the investor may look at the current worth and project the value as it would stand in a year, two years, or five years from the present date. Assuming that no shifts in the economy would threaten that steady but small rate of growth, a conservative investor may find the results of the valuation analysis to indicate that the security is right for inclusion in the portfolio.