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Estimating the True Value of an Asset

Course Section 4 - Lesson 1

What is something worth? There are annoying economists out there who say something is worth what others are willing to pay for it. But that answer leaves a lot to be desired. What we're really asking when we want to know what something is worth: is what a "fair" value for the item is? For most items, it comes down to supply and demand. If there are just a few of the thing and many people want it, the price is high, likewise for the reverse. It can be hard to pinpoint a fair value for most assets.  

Financial assets are different. Because financial assets' primary feature is the cash flows they generate, it's possible to estimate what their "fair" value might be. Pay special attention to the word estimate. It is impossible to know the actual value of an asset beforehand. The best we can do is make an estimate.  

The Time Value of Money

Giving up control of money requires compensation. If you lend $100 to someone that they could start a business, it's unlikely that you would be ok with them just paying back $100 five years from now. You would want something extra in addition to the initial loan amount. That additional amount is what we refer to as interest. Interest has two components: a risk-free component and a risk premium component.  

The risk-free component of interest compensates the lender because they no longer have access to the money to spend on other things.  

The risk-premium component compensates the lender for the risk that they might lose some or all of their initial investment.

Estimating the Value of Risk-Free Asset

Before we tackle the complexities of valuing a complex asset, like a stock, it's important to understand the theory behind how we would compute the price of an asset if all of the future cash flows associated with the investment were known at the time of purchase. There is a financial asset that meets these criteria: a US Government Bond.

US government bonds are the defacto risk-free security because the likelihood that the US will fail to pay its interest and principal on the bonds is so small as to be non-existent. Also, because these bonds have a predefined schedule of payments, both interest and principal, an investor knows exactly what amount and when they will receive cash flows from the bond.

Because everything about these bonds is so predictable, they allow us to anchor a key parameter for valuing all other assets: the Market Interest Rate. If a US government bond pays 1.7% interest over ten years, then we can say with near certainty that the lowest risk investment available will produce a yield of 1.7% for its investors. With this knowledge, every other asset is priced against this risk-free security.

Applying a Risk Premium

If a very safe company, like Walmart, issues bonds, even though it is a near-certainty that they will repay the interest and principle they owe on the bonds, they are still just a hair riskier than US government bonds. Therefore, market participants won't be willing to purchase a Walmart bond unless it offers a yield advantage over a US government bond. We can see this if we compare the two securities: A ten-year government bond yields 1.7%, and a ten-year Walmart bond yields 1.9%. This same principle applies to every financial asset, even those with hard to estimate cash flows.

For instance, if we look at Walmart's stock, we could attempt to estimate every single dividend Walmart will pay from now until the end of time (or when they go out of business). Once we have that long list of estimated cash-flows, we could then "discount" or apply an appropriate interest rate to each individual dividend payment that would properly compensate us for giving up access to our investment and for the risk we might not receive the amount we expected.

This is a valid valuation technique; it's referred to as discounted cash flow analysis. While it can produce a perfect asset valuation, it requires an investor to make many challenging assumptions. For instance, an investor would need to perfectly estimate:

  • Future earnings of the company in question

  • What proportion of profits the company will pay out to investors, and

  • the appropriate risk premium to apply to each dividend 

Each of these is extremely hard to estimate, and to make matters worse, small changes in any of these factors will lead to dramatic swings in the estimated "fair value" of the company.

The Volatility of Value Estimates with DCF Analysis

To demonstrate the volatile nature of DCF analysis, if we were to assume that Walmart was to grow their dividend by 3% each year from now until the end of time and that these dividends should be discounted by a rate of 4.5% to account for their risk, then we can calculate at an estimated value of Walmart's stock of $144. However, suppose we adjust each of these parameters by just 1% and estimate that Walmart will only grow by 2% and that an appropriate discount rate is 5.5%. In that case, we then calculate a fair value of just $64 for Walmart's stock: Less than half of the original estimate.

While it's important to understand this theoretical framework for calculating the value of an asset, because of its extreme sensitivity to the inputs being used, Discounted Cash Flow analysis is not typically a practical methodology to value a stock.  

A Practical Approach to Valuation

In the remaining lessons in this section, we will identify the key drivers of company value and explore a valuation approach that allows us to directly compare companies against each other to find attractive stock investments.

This approach is not only easier to conduct, as it requires making far fewer estimates, it is also more resilient against flaws in judgment that will inevitably find their way into our predictions.

Mark Complete