Valuation of securities is a broad topic, since securities range from stocks and bonds to derivative contracts of various types such as options. In terms of accounting and valuation practice, these financial instruments may require valuation for financial reporting, commercial, or regulatory purposes.
Broadly defined, a security (an abbreviation for financial security) is a financial instrument of one type or another with a recognized financial worth. Generally, a security has the potential to generate some future return above face value. Thus, the value of any given security is the present value of future returns associated with it, adjusted for the time value of money.
Securities valuation for some of the more exotic financial instruments (such as mortgage-backed securities) is a specialized field which departs from the traditional valuation methods used to determine the value of business assets. This article will take a limited view of the valuation of securities, meaning it will focus on those instruments that can be valued using one or more of the three classic valuation approaches (market, income, and cost), and on two common types of corporate securities: stocks and bonds. Valuation of these corporate securities is fairly straightforward, generally relying on readily available information and standard formulas for valuation of securities.
Valuation Of Securities: Valuing Stocks
A stock is a partial ownership or equity stake in a business entitling the owner to dividends, a share of the profits generated by the company. The main factor which influences a company’s stock price is the return on equity, or invested capital, to the shareholder. The return comes in the form of dividends or net earnings of the company. The value of each share is therefore a function of the company’s dividend-paying capacity or its earnings capacity. Dividends may vary from earnings depending on the amount of profits retained by the company for purposes of liquidity, expansion, or capital improvements.
Income Method For Valuing Stock
Shares that are not traded on the market (i.e., private company shares) will have an associated book value; this value is the fraction of the enterprise value of the company associated with each share of stock. The market price of these shares will generally differ from the book value on the basis of investors’ perceptions regarding future earning potential and growth prospects for the company, industry prospects, and the company’s intangible assets such as trademarks and intellectual property.
Value in this scenario would be determined using the income approach, where the future cash flows and costs of capital for the business are forecasted and the terminal value is calculated. The cash flows and terminal value are then adjusted to the present value, debts are subtracted, and the value derived is divided by the number of shares outstanding, yielding the value per share. This approach can also be applied to publicly-traded stocks, to yield a comparison to the current stock price.
An alternative income approach is to forecast the future dividends a shareholder can expect to receive from a stock. This approach is limited to more established, mature companies that pay dividends. Using this approach, the value of future dividends is adjusted to present value. Debts are not subtracted, because under this scenario, only the cash flows anticipated to accrue to the shareholder are being valued.
Market Method For Valuing Stock
The second method for valuing stocks is the market approach. This is the classic approach for stock valuation. Using this method, the Subject Company can be compared to comparable businesses that have sold, and the present value of those sales can be calculated based on the multiples used in prior transactions.
Another approach using the market method is to find similar companies that are currently publicly traded to use as comparables. Comparison of these companies’ stock value metrics—price-to-earnings, price-to-book, and dividends—can be used to estimate the multiples relevant to the Subject Company, and then used to gauge the value of the Subject Company’s stock relative to the comparables’ stock values.
The third valuation approach, the cost approach, is not relevant or used in the valuation of stock. The information required to calculate the cost of replicating the assets of the company is typically not available, and for many public companies, a large portion of overall value is derived from intangible assets, which the cost method cannot explicitly capture.
Both of the market methods for securities valuation rely on having accurate information about the Subject Company’s financial performance. This can be established using the same information used for a typical business valuation.
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Valuation Of Securities: Valuing Bonds
While stocks represent an ownership share or equity stake in a company, bonds represent debt of a company or another entity such as a municipal government. A bondholder has essentially lent money to the company at a specified rate of interest, with the principal to be repaid at a specified date in the future.
Bonds are easily valued because the cash flows are clearly identifiable. The cash flows associated with a bond are the coupon payments on the bond and the maturity principal value of the bond—the amount that the company will repay to the bondholder at the end of the loan period when the bond matures. The coupon payment is the predefined rate of interest the issuer will pay on the loan the bond represents; this rate is usually fixed for the life of the bond. In the U.S., most bonds pay coupons semiannually. The interest paid on a bond is referred to as the bond yield.
Bond yields can vary substantially; typically the bond yield is comparable to the yields of bonds of similar quality. If a bond sells at a discount, that will increase the yield; conversely, if it sells at a premium, it will decrease the yield. In an efficient market, the yield, market rate of discount, and the investors’ required rate of return are all equal.
Because the dates of the anticipated cash flows for bonds are predefined, the process for valuing a bond is straightforward. Cost of capital is calculated to account for the time value of money and risk profile of a borrower, then the bond is valued using the income approach and discounted by the cost of capital. For the valuation of bonds, neither the market nor the cost approaches are relevant unless one has to deal with a distressed situation where a borrower’s assets might need to be sold in bankruptcy to satisfy creditors.
Valuation Of Securities: Derivatives
Derivatives are instruments of value derived from other instruments and as such, are not valued using the standard market, income, or cost valuation approaches. The value of an option might be derived from the value of a stock, but generally the valuation of derivatives is based on complex mathematical models or simulations.
Although valuation of securities differs in some regards from the valuation of underlying securities, the same valuation methods can be applied to the most common forms of financial securities: stocks and bonds. (Tweet this!) Formulas for the valuation of these corporate securities are the same as those typically used in the income and market approaches to valuation. The valuation of more complex financial instruments such as derivatives relies on more complex formulas for securities valuation or custom simulations to incorporate the features of derivative structures.
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Topics: Business valuation
