DISTINCTIONS AMONG VALUATION CONCEPTS
The term value means different things to different people. Therefore, we need to be precise in how we both use and interpret this term. Letâ€™s look briefly at the differences that exist among some of the major concepts of value.
The amount of money that could be realized if an asset or a group of assets(e.g. a firm) is sold separately from its operating organization.
The amount a firm could be sold for as continuing operating business.
Liquidation Value versus Going-Concern value
Liquidation value is the amount of money that could be realized if an asset or a group of assets (e.g. a firm) is sold separately from its operating organization. This value is in marked contrast to the going-concern value of a firm, which is the amount the firm could be sold for as a continuing operating business. These two values are rarely equal, and sometimes a company is actually worth more dead than alive.
The security valuation models that we are discussing in this article are going concernsâ€”operating firms able to generate positive cash flows to security investors. In case where this assumption of going concern is not appropriate (pending bankruptcy), the firmâ€™s liquidation value will have a major role in determining the value of the firmâ€™s financial securities.
1. An asset: The accounting value of an assetâ€”the assetâ€™s cost minus its accumulated depreciation
2. A firm: Total assets minus liabilities and preferred stock as listed on the balance sheet.
The market value of an asset is simply the market price at which the asset (or a similar asset) trades in an open marketplace
Book Value versus Market Value
The book value of an asset is the accounting value of the assetâ€”the assetâ€™s cost minus its accumulated depreciation. The book value of a firm, on the other hand, is equal to the dollar difference between the firmâ€™s total assets and its liabilities and preferred stock as listed on its balance sheet. Because book value is based on historical values, it may bear little relationship to an assetâ€™s or firmâ€™s market value.
In general, the market value of an asset is simply the market price at which the asset (or a similar asset) trades in an open marketplace. For a firm, market value is often viewed as being the higher of the firmâ€™s liquidation or going-concern value.
The price a security â€œought to haveâ€? based on all factors bearing on valuation.
Market value versus Intrinsic Value
Based on our general definition for market value, the market value of a security is the market price of the security. For an actively traded security, it would be the last reported price at which the security was sold. For an inactively traded security, an estimated market price would be needed.
The intrinsic value of a security, on the other hand, is what the price of a security should be if properly priced based on all factors bearing on valuationâ€”assets, earnings, future prospects, management, and so on. In short, the intrinsic value of a security is its economic value. If markets are reasonably efficient and informed, the current market price of a security should fluctuate closely around its intrinsic value.
The valuation approach taken in this article is one of determining a securityâ€™s intrinsic valueâ€”what the security ought to be worth based on hard facts. This value is the present value of the cash-flow stream provided to the investor, discounted at a required rate of return appropriate for the risk involved. With this general valuation concept, the valuation of specific types of securities can be explored in detail.