I spent a great deal of my time to learn how to put a price tag on everything. It’s not easy but it is not impossible, either. There are so many methods that experts can use to value or price an asset for their purposes. However, if you try to categorize all of the methods, it would be only three ways to value anything, well, in theory. Sadly, this post will probably not help you much in valuing a stock, I may try to cover that in the future at length. For now, let just focus on the three ways to value an asset.
The first way stresses how the assets were created, let call it the Cost Approach. Now, try to imagine that you want to buy a car, how are you going to determine the car’s fair value? Well, identifying the cost to build the car can be the answer. So, Cost Approach will try to look into every single step of making the car and conclude the total cost to create the car. For example, if all of the materials and parts cost the manufacturer about $1000, the price should not be lower than $1000. We can next try to identify the value of the technology, the uniqueness, and, maybe, the reputation of the manufacturer. Regardless, the Cost Approach focus mainly on how the expenses to create the asset. As you can easily see, this method has one significant disadvantage. It cannot reflect the opinions of the buyers. If the said car now is not popular and none wants to buy it, it will be very unlikely that the car could be sold at $1000.
As the result, the second approach focuses mainly on how the market participants’ opinions on the asset value, let call it Comparison Approach. In this approach, the expert will not try to identify the cost to create the asset, but rather focus on the value of the asset in comparison with other similar assets. Looking back at the previous example, the buyer now will try to compare the car with other cars from other manufacturers. The process of comparison may need some adjustments. For example, if a comparing car lacks an important feature (like GPRS or hybrid energy), its price should be adjusted up (because if it has that feature, its price will be higher). In other words, the price of an asset should not be higher than the average price of all of the similar assets. Otherwise, the buyer could just go ahead and buy one of the other assets. The main problem with Comparison Approach is that not every asset has an adequate collection of peer assets or some types of asset are simply so unique to compare (paintings, special real estate,…).
The last approach is arguably the best approach to value any asset since it focuses on the potential of the asset, let call it Discounted Cash Flow Approach. The name has explained the idea behind the approach. The Discounted Cash Flow Approach will try to identify all of the cash flows that the asset can generate in the future (even in perpetuity). “Cash flow” is not necessarily cash, it could be profit, dividends and any type of earnings that the analyst cares about. Come back to the car example, the buyer now will try to estimate the benefit of owning that car: how much money he or she could make out of the car? How much cost could be saved? If the owner decides to sell the car in 5 years from now, how much should he or she get? Then, when all of the cash flows are identified, the buyer will discount all of this cash flows back to present value and come to the fair value of the car. Now, let take a closer look at Discounted Cash Flow Approach. The process of identifying the cash flows focuses on the potential of the asset and, thus, the concluded value will reflect better the benefits of owning the asset. Also, the discounted rate will reflect the general expectation from the market and the opinions of market participants. It is, as the result, generally considered the best approach to value an asset…in theory.
Do you find something odd about all of the approaches I wrote? It seems like the better the valuation method is, the less we care about the asset itself. We start to care more about the opinions of other people and the benefits of owning the asset because we simply do not want to pay more than what most people agree to pay for the same asset. The valuation process becomes a game of guessing other opinions rather than focus on your own opinions. It is just like a classic example in finance. Imagine you are a judge in a beauty contest and you were asked who YOU think will be the winner. Now, to answer that question, you will not try to figure out who you think is the most beautiful but you will try to determine the lady that most of the judges will find the most beautiful. Thus, despite the question is about you, the answer is more likely from others.