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.
