Valuation Concepts: Valuation is based on economic factors, industry variables, and an analysis of the financial statements and the out look for the individual firm. The purpose of valuation is to determine the long-run fundamental economic value of a specific company’s common stock. When a firm is considering the purchase of marketable securities- debt, preferred stock or common stock– it must have some knowledge of investment value. If the firm is evaluating an acquisition it must have techniques to determine how much to pay for the stock to be acquired. When a firm is considering a public offering to sell its own stock in order to raise additional equity capital, it must establish a price for the issue and the time the offering to achieve a maximum benefit to existing shareholders. These are all issues related to the valuation of the firm and its securities.
The valuation of a security is defined as its worth in money or other securities at a given moment in time. The value is expressed either in terms of a market for the security or in terms of the laws or accounting procedures applicable to the security.
Five major concepts of valuation
In this regard, five major concepts of valuation may be discussed in the following manner.
- Going Concern Value: The value of the securities of a profitable operating firm with prospects for indefinite future business might be expressed as a going concern value. The worth of the firm would be expressed in terms of the future profits, dividends, or expected growth of the business.
- Liquidation Value: If the analyst is dealing with the securities of a firm that is about to go out of business, the net value of its assets, or liquidation value, would be of primary concern
- Market Value: If the analyst is examining a firm whose stock or debt is traded in a security market, he can determine the market value of the security. This is the value of the debt and equity securities as reflected in the bond or stock market’s perception of the firm.
- Book Value: This is determined by the use of standardized accounting techniques and is calculated from the financial reports, particularly the balance sheet, prepared by the firm. The book of the debt is usually fairly close to its par or face value. The book value of common stock is calculated by dividing the firm’s equity on the balance sheet by number of shares outstanding.
- Intrinsic Value: A security’s intrinsic value is the price that is justified for it when the primary factors of value are considered. In other words, it is the real worth of the debt or equity instrument as distinguished from the current market price. The financial analyst estimated intrinsic value by carefully appraising the following fundamental factors affecting security value:
- a) Value of the firm’s assets: The physical assets held by the firm have some market. They can be liquidated if need be to provide funds to repay debt and distribute to shareholders. In technique of going concern valuation, asset values are usually omitted.
- b) Likely future interest and dividends: For debt the firm is committed to pay future interest and repay principal. For preferred and common stock, the firm makes attempts to declare and pay dividends. The likelihood of these payments affects present value.
- c) Likely future earnings: The expected future earnings of the firm are generally viewed as the most important single factor affecting security value. Without a reasonable level of earnings, interest and dividend payments may be in jeopardy.
- d) Likely future growth rate: A firm’s prospects for future growth are carefully evaluated by investors and creditors as a factor influencing the intrinsic value.
Analysis of Intrinsic Value
Analysis of intrinsic value is the process of comparing the real worth of a security with the current market price or proposed purchase price. The fundamental factors affecting value usually change less rapidly than the market price of a security. In imperfect market, the analyst can hope to locate variance between intrinsic value and the asking price for a security. The primary goal of analyzing intrinsic value is to locate clearly undervalues or clearly overvalued firms or stocks. In the case of an undervalued security, the market has not discovered that fundamental factors justify a higher market price. That is, the security is worth more than its selling price. For overvalued stock, the reverse situation is true.