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Asset Valuation — Definition, Methods, Approaches, and Importance

by Jack Bodeley on September 30, 2021

Asset valuation is the process of determining the fair market or present value of assets using book values and valuation and pricing models. Valuation is determining the current (or projected) economic worth at a given time period.

What is an Asset in Valuation?

In valuation, an asset generally refers to any financial security that can be traded in the market.

These assets include marketable securities such as stocks, bonds, preferred shares, and ETFs, money market instruments such as futures, options and so on and so forth.

The four main types of assets in asset valuation are — debt, equity, derivaties and hybrid securities.

Absolute v Relative Valuation

Absolute Valuation is a method of determining present value by forecasting future cashflows or income streams using discounting methods.

Generally, absolute valuation uses the Discounted Dividend Model (DDM) and the Discounted Cash Flows Method (DCF) to determine present value. DDM sums discounted future dividend payments whereas DCF sums discounted future cash flows.

Relative Valuation is a method of determining value through comparison with alternatives or the competition.

The worth of a firm, for instance, can be determined by comparison with that of it's rivals or competitors. The value of a stock can, likewise, be determined by comparison to the stock value of it's competitors or peers within the same industry—this is fairly common, in practice.

Perhaps, one of the most financial ratios used in relative asset valution is the the Price-to-earning (P/E) ratio. A company with a higher P/E ratio than that of it's peers might be overvalued and viceversal.

Asset Valuation Methods

Some of the methods of asset valuation are:

#1 — Historical Cost Method

This is perhaps the easiest and most common method. Assets are valued at the price they were bought. It's also called the book value method.

#2 — Market Value Method

This method bases the value of the asset on its market price i.e. the price an asset would fetch when offered in an open market.

In practice, market price is estimated by how much similar assets are fetching in the open market. In the abscence of similar assets in the open market, the replacement method or net realizable value is used.

#3 — Base Stock Method

The base stock method requires a firm to maintain a certain level of stock—called a base stock. The firm's value is then assessed through the value of that stock.

#4 — Standard Cost Method

The standard cost method uses expected costs instead of actual costs often based on the company's past experience.

Asset Valuation Approaches

There are two main approaches in asset valuation:

  1. Traditional approach
  2. Modern approach

Traditional Approach

Some examples of traditional approaches are:

  • Payback Period
  • Accounting Rate of Return (ARR)

Modern Approach

The modern approach uses discounted cash flow technique to value assets. Some examples are modern approaches are:

  • Net Present Value (NPV)
  • Internal Rate of Return (IRR)
  • Profitability Index (PI)

Importance of Asset Valuation

There are many reasons for valuing assets including:

#1 — Pricing Decisions

Asset valuation helps identify the correct value and price of an asset, particularly if it is to be offered for sale or purchased. This is benefitial for both buyers and sellers in determining fair price.

#2 — Taxes

Every one who owns an asset needs to determine their tax liability. Taxes cannot be assessed accurately without asset valuation.

#3 — Mergers & Acquisitions

Asset valuation is important when two companies are merging or in acquisitions because it helps determined the value of assets.

#4 — Borrowing

Banks, lendors and creditors need collateral incase of debt default. Asset valuation helps determine the value of that collateral, hence loanable amounts against that collateral.

#5 — Auditing

Audits use valuation to determine whether reported values of assets are accurate.