Show Me the Money: The Basics of Valuation
To invest wisely, you need to understand the basics of valuation. In general, you can value an asset in one of three ways. You can estimate the intrinsic value of the asset by looking at its capacity to generate cash flows in the future. You can estimate a relative value by examining how the market is pricing similar or comparable assets. Finally, you can value assets with cash flows that are contingent on the occurrence of a specific event (options).
With intrinsic valuation, the value of any asset is a function of the expected cash flows on the asset, and it is determined by the magnitude of the cash flows, the expected growth rate in these cash flows, and the uncertainty associated with receiving these cash flows. We begin by looking at assets with guaranteed cash flows over a finite period, and then we extend the discussion to cover the valuation of assets when there is uncertainty about expected cash flows. As a final step, we consider the valuation of a business with the potential, at least, for an infinite life and uncertainty in the cash flows.
With relative valuation, we begin by looking for similar or comparable assets. When valuing stocks, these are often defined as other companies in the same business. We then convert the market values of these companies to multiples of some standard variable—earnings, book value, and revenues are widely used. We then compare the valuations of the comparable companies to try to find ...