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When investing, it is important to estimate the valuation of a financial asset or liability. Basically, this is the process of finding the potential market value of a financial instrument. Every type of investment from stocks to options to bonds can go through the process of valuation. This is a requirement when performing an investment analysis or financial report. While there are a number of ways to determine the estimated value of a asset or liability, finding the right method depends on experience and preference.
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Best Models for Investors and Business Owners
One method in estimating valuation is by comparing the chosen instrument to other similar products. If one knows the market price of the other assets or liabilities, one can determine its relative value. This is known as the guideline companies method. The market price can be observed by looking simply at stock share price, a company's earnings or the book value of the instrument. For example, two companies with the same product, market share, management structure and business model are more likely to have similar values than two divergent companies.
One can find the absolute value of an instrument by calculating an estimate of future earnings and discount that estimate to its present value. This is known as the discounted cash flow method. For example, when an asset matures in one year and will pay $100, it is considered to have a value of less than $100 today. This principle is referred to as the time value of money.
Comparing cash flows at different times can also help determine valuation. One determines the date of a future payment and discounts its price using factors such as time frame and risk. For example, the cash flow of a firm one month can be used to determine the cash flow in one year's time taking into account acceptable growth rate and market fluctuations.
Options can be valued using the Black-Scholes model. This equation allows an investor to determine the valuation with the knowledge that it varies due to time frame and overall stock price. The mathematics formula was established in 1973 by Fischer Black and Myron Scholes and states that the option price is defined by the price of the traded stock.
In order to value a new stock's benefit or risk to a portfolio, the concept of the capital asset pricing model can be used. This concept weighs the market risk of an asset with the expected rate of return. If an investor requires a particular rate of return on a security, measuring whether it will perform as well as expected helps determine its value to a portfolio.
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Importance of Valuation
By using any of these methods, one can determine the estimated valuation of a financial instrument. This helps determine a number of factors regarding whether an investor should buy or sell the instrument. Valuation also helps determine fair market value of an asset or liability, showing what price a reasonable investor would pay to make a purchase. This can be balanced with the theory of fair price, which determines what the price should be in a stable market. By finding the valuation and determining the current and potential prices on an instrument, one can make sound investment decisions.
Before adding any financial instrument to one's portfolio, it's very important to determine the overall effect it will have as well as if its overall value is worth the risk.
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"How Much are Stocks Worth?" MoneyChimp (http://www.moneychimp.com/articles/valuation/stockvalue.htm)
"Valuation" New York University (http://pages.stern.nyu.edu/~adamodar/pdfiles/ovhds/ch12.pdf)