The youngster had been on loan at the Mestalla, but now Los Che have decided to complete a transfer for the gifted attacking midfielder
The 21-year-old originally joined Los Che on a two-year loan deal at the start of last season but only made 11 league appearances for the club as he struggled with injuries. However, Mauricio Pellegrino's side have still exercised their right to purchase the player permanently.
A statement on the Madrid club's official website read: "Real Madrid and Valencia have concluded the agreement for the transfer of Sergio Canales. Real Madrid reserves a right of repurchase."
The Santander-born youngster has represented Spain at every level from Under-16 to Under-21 but is yet to make his first senior international appearance.
Canales struggled to make his mark during his time in Madrid and becomes the second player to swap the Santiago Bernabeu for Valencia this season after Fernando Gago made the switch on July 19.