All assets can be valued, be they stocks, bonds, derivatives, real estate, personal property and many others. It can be difficult to reconcile your own ideas about the market value of a security with other ideas you may hold about what the asset is worth to you. You may have heard other people say that an illiquid security, such as privately held stock in a small company, is only worth what someone is willing to pay for it. In a sense this is true, although a hypothetical deal price is only one of many baselines for determining the value of a security.
Purpose and Standard of Value
The purpose of the valuation typically determines what standard of value is used. Standards of value include fair market value, fair value, investment value and orderly liquidation value, among others. Fair market value is a notional value. If you purchased a minority interest in a closely held company that has never distributed earnings to shareholders and never intends to, you may feel strongly that the value of the interest is zero. You cannot sell it, because no secondary market exists for the company’s stock. However, the company may still be profitable and growing, which is accounted for in a notional value. A hypothetical strategic buyer of the whole company may estimate the company’s investment value to be higher than its fair market value due to expected synergies, financial benefits generated by increased scale, it expects to earn post-transaction.
Cash Flow and Risk
Ultimately, all valuations are driven by cash flow, risk and growth. This applies across all asset classes. Real estate, equity, derivatives and fixed income securities are all valued based on the present value of the cash flows it is expected to generate during its lifetime. Cash flows are forecasted and the present value factor is determined using an appropriate discount rate reflecting the risk associated with an investment in the security. The challenge is to accurately estimate future cash flows and the uncertainty associated with the accuracy of the estimates.
Three basic approaches are used to value all securities: the asset-based, income and market approach. In valuing real estate using the market approach, cash flows are represented by dollars per square foot, and comparable property sales are obtained to determine the average market price per square foot. In valuing stocks, comparable transactions of similar companies are used to develop valuation ratios applied to the subject company’s financial metrics such as earnings and cash flow. Valuation ratios such as price to earnings used in the market approach are used to convert income streams into value. This is the same purpose discount rates are used for, to calculate the present value factor applied to future income streams.
Net Asset Value
In certain cases, such as in real estate, the reproduction cost of a property can also be considered a proxy for valuation. A property is generally worth the approximate cost to build it. Similarly, if a company is not profitable, investors may find that the most value that can be extracted from an investment in the company may be via its orderly liquidation. If the present value of future cash flows is lower than the book value of a company, this demonstrates that a low return of assets is being generated and the value of the company is captured within the liquidation value of assets it may hold such as cash and real estate.
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