Value

Lecture 10

This lecture is part of Chapter 5:Becoming a Millionaire

Today’s Lecture

What kinds of value are there?

ReligionPolitics

Art

In business, this is not really how we categorize value.

Value

General Value

Book Value

Intrinsic Value

Market Value

Liquidation Value

These are most common types of value in business

General Value

In very general terms one could call the value of a business the amount a purchaser and a seller agree upon during the sale of the business.

In this sense, the value of the asset is equal to its price. This is, however, not always the case. The price of an asset can also be higher than its (or one of its types of) value(s) or lower than its (or one of its types of) value(s).

Book Value

Book value of an asset: This is simply the purchase price of an asset minus its accumulated depreciation.

• This is important for accounting but often a poor reflection of the true value of an asset.

Book value of a stock: This is the amount of owner’s equity per share.

• Be aware that this is very different from Market Value.

Intrinsic Value

Intrinsic value is the value an investor assigns to an asset. This is a highly individual matter and hence the intrinsic value of an asset is different for each investor.

Generally, an investor would look at the cash flows of an investment (e.g. the dividends plus the proceeds of the sale of the stock at the end of the expected holding period), discount them with an expected rate of return and thus determine its intrinsic value.

The differences in perception are an importantingredient for the functioning of the financial markets.

Market Value

The market value of an asset is the price one would pay for that asset in a competitive market place.

The same, of course, is true for a stock with the market place being the stock market.

Boom or Gloom?

Liquidation Value

This is how much a business would fetch in a fire-sale. The liquidation value of certain assets can be extremely low since those assets may not be of any use to other parties.

ExamplesPokemon Card:

General Value: 12 dollars. The price you just bought it for from a friend.

Book Value: 12 dollars. Not much depreciation in a Pokemon card.

Intrinsic Value: 30 dollars. It was the only card you were missing!

Market Value: 8 dollars. Actually, at the fair, many people turned out to havethis card.

Liquidation Value: 0.01 cents. The paper isn’t worth much

Examples

Pokemon Card:

You don’t agree with my reasoning here?

Excellent!

That’s exactly the point. Opinions on what constitutes value are diverse. Always keep that in mind when considering value statements.

Examples

Coffee Shop:

General Value: 500K. The price someone has just offered.

Book Value: 200K. Your 250K investment minus 50K depreciation.

Intrinsic Value: 250K. You didn’t like the idea of running a shop and you just want your money back.

Market Value: 100K. Enough Starbucks already!

Liquidation Value: 20K. Won’t get anything back for the renovation … Only little for the rest.

Examples

Coffee Shop:

Again … much to debate. Numbers themselves do not lie but the question is of course:

What do they mean?

Valuation

One of the fundamentals of valuation is the value of future cash flows. In other words, the intrinsic value. Mathematically, it is exactly the same as what we have done in the lecture on the time value of money.

Let us have a look at this again:

Valuation of future Cash Flows

This is the same spreadsheet we used before:

A B C D E F G H I23 How much is a stream of cash flows worth?45 Present Value 8,986.20 6 Discount Rate 10%78 In Cash9 years Flow1011 1 1,000.0012 2 1,300.0013 3 1,200.0014 4 1,500.0015 5 1,400.0016 6 1,600.0017 7 1,700.0014 8 1,750.0015 9 1,900.0016 10 2,100.00

=NPV(D6,C11:C20)

Discount Rate

Range of Cash Flows

Risk

There’s of course nothing wrong with this calculation but the determined present value assumes the stream of cash flows to be certain.

In real life, one can never be entirely certain of future cash flows and one therefore needs to take risk into account.

Risk

Generally speaking, the expected rate of return should increase when the risk increases and decrease when the risk decreases.

Hence, the expected return on US government bonds (very little risk) is lower than than that of stocks (a company might go bankrupt).

Capital Asset Pricing Model

A simple way to relate risk and return is the Capital Asset Pricing Model (CAPM).

It is defined as:

)( fmifi RRRR

Expected return on investmentRisk free investment

Expected return of market

Relative risk of investment

Capital Asset Pricing Model

Of course we can use Excel to express this:

A B C D E F G H I23 Capital Asset Pricing Model456 Risk Free Company X Market Company Y7 Beta 0.00 0.50 1.00 1.508 R 5.75% ? 10.00% ?91011121314151617141516

What would this be?

Expected Rate of Return

Capital Asset Pricing Model

Of course we can use Excel to express this:

A B C D E F G H I23 Capital Asset Pricing Model456 Risk Free Company X Market Company Y7 Beta 0.00 0.50 1.00 1.508 R 5.75% ? 10.00% ?91011121314151617141516

What would this be?

)( fmifi RRRR

Just enter the formula!

Risk

Mathematics! I can’t do that!

Change you mind-set!

Help!!!!

Capital Asset Pricing Model

Of course we can use Excel to express this:

A B C D E F G H I23 Capital Asset Pricing Model456 Risk Free Company X Market Company Y7 Beta 0.00 0.50 1.00 1.508 R 5.75% 7.88% 10.00% 12.13%91011121314151617141516

)( fmifi RRRR

=$C$8+D7*($E$8-$C$8)Hey! That’s the same!

Math is easy when you understand what you’re doing!

Capital Asset Pricing Model

A graph would be nice…:

A B C D E F G H I23 Capital Asset Pricing Model456 Risk Free Company X Market Company Y7 Beta 0.00 0.50 1.00 1.508 R 5.75% 7.88% 10.00% 12.13%91011121314151617141516

CAPM

5.7

5%

7.8

8%

10

.00

%

12

.13

%

0.00%

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60

Beta

Exp

ecte

d R

etu

rn

Indeed!

Risk

fi RR

fi RR

Of course, this still leaves us with the problem of how to determine the beta ….

Basically, beta is the relationship between the return of a security and the overall market return.

Beta = slope of this line

Market Return -Risk Free

Secu

rity

Ret

urn

- R

isk

Free

... .

. . .... .

.. .

...

. ..

But of course using past datato draw conclusions about the future ….

fm RR

Key Points of the Day

Different types of values

Capital Asset Pricing Model