10.1 Fundamentals of Value and Valuation

Valuation is the process of determining an asset's worth. This topic covers key concepts like intrinsic value, market value, and book value. It also explains why valuations are conducted and how purpose impacts the approach taken.

Financial concepts crucial to valuation include time value of money, discounted cash flow, and risk-return tradeoffs. Understanding cost of capital and how to calculate it is essential for accurately valuing assets and investments.

Valuation Fundamentals

Types of Value

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• Intrinsic value represents the true, underlying worth of an asset based on its fundamental characteristics and future cash flows
• Market value refers to the current price at which an asset trades in the open market, determined by supply and demand factors
• Book value is the value of an asset as recorded on a company's balance sheet, calculated as the original cost minus accumulated depreciation
• Fair market value estimates the price at which an asset would change hands between a willing buyer and seller, assuming both parties have reasonable knowledge and are not under duress

Valuation Purpose

• Valuation purpose defines the reason for conducting a valuation, which can impact the assumptions and methods used
• Common purposes include financial reporting (determining the value for accounting statements), investment analysis (assessing potential returns), and strategic decision-making (evaluating mergers, acquisitions, or divestitures)
• The purpose of the valuation guides the selection of appropriate valuation techniques and the interpretation of results
• Valuations may also be required for tax purposes (estate planning or transfer pricing) or legal proceedings (divorce settlements or bankruptcy)

Financial Concepts

Time Value of Money and Discounted Cash Flow

• Time value of money is the principle that money available now is worth more than an identical sum in the future due to its potential earning capacity
• This concept is crucial in valuation as it allows for the comparison of cash flows occurring at different points in time
• Discounted cash flow (DCF) is a valuation method that estimates the present value of future cash flows by applying a discount rate to account for the time value of money
• The DCF approach involves forecasting future cash flows, determining an appropriate discount rate, and calculating the sum of the discounted cash flows to arrive at the present value

Risk and Return

• Risk refers to the uncertainty or variability of returns associated with an investment, while return represents the gain or loss on an investment over a specific period
• Investors generally expect higher returns for taking on greater risk, known as the risk-return tradeoff
• Systematic risk (market risk) affects the entire market and cannot be diversified away, while unsystematic risk (company-specific risk) can be reduced through diversification
• The Capital Asset Pricing Model (CAPM) is a widely used framework that describes the relationship between systematic risk and expected return, helping to determine the required rate of return for an investment

Cost of Capital

• Cost of capital represents the minimum rate of return required to attract funds for a particular investment, considering its risk
• It is used as the discount rate in DCF valuations to account for the time value of money and the riskiness of future cash flows
• The weighted average cost of capital (WACC) is a common measure that combines the costs of equity and debt, weighted by their respective proportions in a company's capital structure
• The cost of equity can be estimated using the CAPM or other methods like the dividend discount model, while the cost of debt is based on the company's borrowing rates and tax considerations