Corporate Finance

Unit: Valuation Fundamentals

Subhas Chakrabarti
M.Com. M.Phil. B.Ed. ICWA (Int) DCFA
Member of the AIAA

Valuation is the process that links risk and return to

estimate the worth of an asset or a firm. The term value can
have different meanings when applied to a financial asset or
a firm. Broadly defined, a financial asset is a monetary
claim on an issuer, typically a paper asset such as a bond,
preferred stock, or common stock. These different types of
value include:

• Going-concern value. Going-concern value is the value

of a firm as an operating business. This type of value
depends on the firm’s ability to generate future cash flows
rather than on its balance sheet assets. Going-concern value
is particularly important when one firm wants to acquire
another.

• Liquidation value. Liquidation value is the amount of

money that a firm would realize by selling its assets and
paying off its liabilities. A firm’s assets are generally worth
more as a going concern than they are worth separately.
Liquidation value per share is the actual amount per
share of common stock that stockholders would receive if
the firm sells all assets, pays all its liabilities including
preferred stock, and divides any remaining money among
them.
• Book value. Book value is the accounting value of a firm
or an asset. Book value is an historical value rather than a
current value. Firms usually report book value on a per share
basis. Book value per share of common stock is the
shareholders’ equity – total assets less liabilities and
preferred

stock as listed on the balance sheet – divided by the number

of shares outstanding. Book value per share may bear little
relationship to liquidation value per share or market value
per share.

• Market value. Market value is the price that the owner

can receive from selling an asset in the market place. The
key determinant of market value is supply and demand for
the asset. For stocks and bonds, market values reflect
current market prices.

• Intrinsic value. Intrinsic value, also called fundamental

value, is a measure of the theoretical value of an asset.
Because determining the intrinsic value requires estimates,
we may never know the “actual” or “true” intrinsic value of
some financial assets. Nonetheless, intrinsic value serves as
a basis for determining whether to buy or sell a financial
asset when compared to its market value or price.

These various types of value – book value, market value and

intrinsic value – can differ for the same financial asset. For
example, in a market in which security prices rapidly reflect
all information about securities, called an efficient capital
market, the intrinsic value of a security is equal to its
market value. In less than perfectly efficient markets, market
value and intrinsic value may differ. Although controversy
surrounds the degree of market efficiency, most experts
agree that the capital markets are not perfectly efficient.
Thus, mispricing may occur for financial assets.
In this Study, we focus on estimating the intrinsic value of
three types of financial assets
– Bonds, Preferred stock, and Common Stock.
We do not examine valuation of the overall firm. Corporate
managers, especially financial managers, need to know how
to estimate the intrinsic value of financial assets to
determine if the market properly prices these

assets. Financial managers also need to estimate the price

that their firms are likely to receive when issuing bonds or
shares of common or preferred stock.

In addition, financial managers need to understand how

corporate decisions may affect the value of their firm’s
outstanding securities, especially common stock. For
example, financial management decisions determine the
risk/return characteristics of the firm. These decisions cause
both cash flows and the required rate of return to change,
which in turn cause changes in the firm’s stock price.
Analysts and investors often compare the current market
price of a security to the intrinsic value they estimate from a
security valuation formula. If the estimate of intrinsic value
exceeds an asset’s market value (price), investors would
consider buying the asset.

Conversely, if the market value (price) exceeds the

estimated intrinsic value, investors would not consider
buying the asset (or would consider selling if they own it).
Because the financial rewards from identifying an
undervalued or overvalued security can be great, many
analysts and investors devote substantial time and resources
to developing innovative security valuation models,
especially for common stock.

Reference Questions:
1 What is valuation?
2 What are five types of value? How do they differ?
3 Under what circumstances can the market value and intrinsic value of a financial asset differ?
4 Why should a financial manager understand the valuation process?
5 How does discounted cash flow (DCF) valuation differ from relative valuation?