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Subject 1. What is Value? PDF Download
Valuation is the estimation of an asset's value based on:

  • Comparison with similar assets (relative valuation), or
  • Variables perceived to be related to future investment returns (absolute valuation), or
  • Estimates of immediate liquidation process.

There are different definitions of value.

The intrinsic value of an asset is the value of the asset given a hypothetically complete understanding of the asset's investment characteristics. In other words, it is the perceived actual value of a security, as opposed to its market price or book value.

When an investor identifies mispricing of an asset, he can expect to earn positive excess risk-adjusted return (abnormal return) upon the convergence of the asset's price to its intrinsic value.

  • Mispricing is calculated as the difference between the estimated intrinsic value (V) and the market price (P) of an asset.
  • Abnormal return, or alpha, is the difference of expected return on asset and the required rate of return, justified by the risk of such investment.

VE - P = (V - P) + (VE - V)

V - P: the true mispricing.
VE - V: the error in the estimate of the intrinsic value.

Going-concern assumption: A term for a company that has the resources needed in order to continue to operate. If a company is not a going concern, it means the company has gone bankrupt. In other words, this refers to a company's ability to make enough money to stay afloat. For example, many dotcoms are no longer a going concern.

Most models employ forecasts of a company's fundamentals as inputs that allow analysts to estimate the stock's intrinsic value. If the company does not have a future, these forecasts are misleading and the intrinsic value should be estimated without the going-concern assumption. In that case, the value of the company should be determined by the company's liquidation value.

Liquidation literally means turning a business's assets into readily available cash. The liquidation value is the estimated amount of money that an asset or company could quickly be sold for, such as if it were to go out of business.

In a normal growing profitable industry, a company's liquidation value is usually much less than the going concern value. In a dying industry, however, the liquidation value may exceed the going concern value. If a company is expected to constantly decrease shareholders' capital by engaging in projects with negative NPV, it is better to dissolve the company, since more value will be derived for shareholders form the sale of the company's assets. Such ineffective companies are usually prime targets for acquisitions.

Assuming that such opportunities are quickly identified in the effective market, a company's fair market value is the higher of going concern value or liquidation value. The fair market value is the price at which an asset (or liability) would change hands between a willing buyer and a willing seller when the buyer (seller) is not under any compulsion to buy (sell). If the marketplace has confidence that the company's management is acting in the owners' best interest, market prices should on average reflect fair market value.

Intrinsic value, estimated under a going-concern assumption, is the focus of these equity valuation readings.

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