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2. Different Methods of Valuation
Different investments require different methods of valuation. Learn about each valuation method and when to use them in this short lesson.
Different methods of valuation
- Different types of assets can require different method(s) of valuation
- In this course, we'll cover 3 different methods of valuation
1 Income-based valuation
- Value is a function of the expected future cashflows of an asset
- Requires a lot of assumptions about the future
- More suited to assets with low uncertainty and stable cashflows
2 Market-based valuation
- Value is a function of the selling price of a similar asset
- Uses a comparable ratio between similar assets to determine valuation
- Easier to calculate than income-based valuation
- However, this method is very prone to market-cycles
3 Cost-based valuation
- Value is a function of the cost of re-producing or replacing an asset
- Often used when replacing plant machinery or during liquidations
- This valuation method will not be a major focus in this course
There are three basic ways of valuing assets.
The first of these, income-based valuation is forward looking.
Market-based is sideways looking, and cost-based valuation, which is backward looking.
When valuing an asset, the method you choose will depend primarily on the type of the asset in question.
Let's take a look at these three methods now individually.
Income based valuation states that an asset is a function of the expected future cash flows on that asset.
Income based valuation requires a lot of assumptions about the future and hence is most suited to assets with low levels of uncertainty and stable cash flows.
Income based valuation has a very strong theoretical basis.
But in reality, most assets are valued based on market prices.
In market based valuation, we value an asset based on the current or recent price of a similar asset.
The metric we use to compare similar assets depends on the asset in question.
Market based valuation is much easier than income based valuation, but it’s not forward looking, and is very prone to market cycles.
To understand market based valuation in more detail, let's take the example of two similar houses on the same street.
Both with 4 bedrooms, a similar garden, kitchen and living area.
The smaller house has 3,000 square feet and is on sale for $450,000.
This gives us a comparing metric of $150 per square foot.
The larger house has 3,250 square feet of area and is on sale for $460,000.
Its dollar per square foot is priced at $141.
Let's now assume that the smaller house is sold for the asking price.
On a market based valuation, the larger house should now increase its price to $487,500, which corresponds to the comparing metric of $150 per square foot.
As I mentioned earlier, the metric we used to compare assets depends on the asset in question.
If we’re investing in property, we might use price per square foot as in the last example, or price divided by annual rent, which is also called the rental yield.
If we’re investing in company stock, we might use price divided by earnings, or price divided by book value.
And if we’re investing in start ups, which typically have very little revenue, we might have priced per signed up user.
I'll be covering these metrics in much more detail later in the course.
The last method of valuation is called cost based valuation, and is the most conservative of the three methods.
It simply calculates the cost to reproduce or replace the current asset as is.
The method is backward looking and doesn't take into account the future cash flows or the market price of an asset.
It tends to be used most often by managers when replacing machinery and long term assets, or when a company has been liquidated and is no longer a going concern.
Let's start examining these valuation methods in detail in the next lesson, beginning with income based valuation.