The Basics of Asset Valuations

Investors generally expect assets they have purchased to offer a stream of cash flows (or returns) during the period of time that those same assets are held in their portfolios. But in order to “convert” these expected streams of cash flows into an actual value for the security, cash flows have to be discounted at the investor’s required rate of return. As you can see, value of securities and rates of return are very closely held.

Estimating Expected Cash Flows (Returns)

When estimating expected cash flows, the process involves not only the size of cash flows, but also their form, how often they are dispersed, and how certain they may or may not be, all of which has a direct impact on the required rates of return.

There are many forms of cash returns, such as a company’s net earnings, interest payments from fixed income securities, dividends from preferred and common equity, or capital gains after deemed dispositions of assets. For example, common equity can be evaluated by applying earnings multiplier calculations. Another approach to evaluating common equity is to estimate the present value of a stock’s dividend payments.

One of the key factors in cash flow calculations is knowing when an investor will receive its cash flows or returns. This "time" component is of paramount importance because money has time value, which, when combined with the growth rate of return on an investment, provides for adequate tools when evaluating certain types of assets.

Required Rates of Return

When calculating the required rate of return, the calculation contains three important variables:

• the economy’s real risk-free rate of return;
• the expected rate of inflation during the holding period; and,
• the expected growth rate of returns from an investment.

Note that all investments are greatly impacted by the risk-free rate and the expected rate of inflation because these rates largely establish the nominal risk-free rate. In addition, note that the component that creates a difference between the required and actual rates of return is referred to as the risk premium that was forgone, but which could have been earned on alternative investments. Closing the circle, note that this risk premium largely depends on the (un)certainty of an asset’s cash flows.

Sources of volatility of returns can stem from within a company or from the market itself. “Internal” sources of volatility can be further divided into business risk, financial risk, liquidity risk, exchange rate risk and country risk, while market-generated sources of risk include assets’ systematic risks (betas), or market-related components contained in multiplier calculations.

Comparing Estimated and Market-Determined Values

Once an investor has estimated his required rate of return, as well as an investment’s intrinsic value, the next step is to compare the results of his analysis with current market values (prices). This last step is very simple:

• if an asset’s estimated intrinsic value is greater than its market price – buy;
• if an asset’s estimated intrinsic value is less than its market price – don’t buy or sell if you already hold it

Money Makes the World Go 'Round

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