Basic Asset Valuation
In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company). Valuations are needed for many reasons such as investment analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability, and in litigation.
Overview
Valuation of financial assets is done using one or more of these types of models:
- Absolute value models that determine the present value of an asset's expected future cash flows. These kinds of models take two general forms: multi-period models such as discounted cash flow models or single-period models such as the Gordon model. These models rely on mathematics rather than price observation.
- Relative value models determine value based on the observation of market prices of similar assets.
- Option pricing models are used for certain types of financial assets (e.g., warrants, put/call options, employee stock options, investments with embedded options such as a callable bond) and are a complex present value model. The most common option pricing models are the Black–Scholes-Merton models and lattice models.
- Fair value is used in accordance with US GAAP (FAS 157), where fair value is the amount at which the asset could be bought or sold in a current transaction between willing parties, or transferred to an equivalent party, other than in a liquidation sale. This is used for assets whose carrying value is based on mark-to-market valuations; for fixed assets carried at historical cost (less accumulated depreciation), the fair value of the asset is not used.
Common terms for the value of an asset or liability are fair market value, fair value, and intrinsic value. The meanings of these terms differ. For instance, when an analyst believes a stock's intrinsic value is greater (less) than its market price, an analyst makes a "buy" ("sell") recommendation. Moreover, an asset's intrinsic value may be subject to personal opinion and vary among analysts.
When a plant asset is purchased for cash, its acquisition cost is simply the agreed on cash price. However, when a business acquires plant assets in exchange for other non-cash assets (shares of stock, a customer's note, or a tract of land) or as gifts, it is more difficult to establish a cash price. This section discusses three possible asset valuation bases.
Emerging Values: Environmentalism and Green Energy
Image of an energy plant.
The general rule on non-cash exchanges is to value the non-cash asset received at its fair market value or the fair market value of what was given up, whichever is more clearly evident. The reason for not using the book value of the old asset to value the new asset is that the asset being given up is often carried in the accounting records at historical cost. In the case of a fixed asset, its value on the balance sheet is historical cost less accumulated depreciation, or book value. Neither amount may adequately represent the actual fair market value of either asset. Therefore, if the fair market value of one asset is clearly evident, a firm should record this amount for the new asset at the time of the exchange.
Appraised Value
Sometimes, neither of the items exchanged has a clearly determinable fair market value. Then, accountants record exchanges of items at their appraised values as determined by a professional appraiser. An appraised value is an expert's opinion of an item's fair market price if the item were sold. Appraisals are used often to value works of art, rare books, antiques, and real estate.
Book Value
The book value of a fixed asset asset is its recorded cost less accumulated depreciation. An old asset's book value is usually not a valid indication of the new asset's fair market value. However, if a better basis is not available, a firm could use the book value of the old asset.
Occasionally, a company receives an asset without giving up anything for it. For example, to attract industry to an area and provide jobs for local residents, a city may give a company a tract of land on which to build a factory. Although such a gift costs the recipient company nothing, it usually records the asset (land) at its fair market value. Accountants record gifts of plant assets at fair market value to provide information on all assets owned by the company. Omitting some assets may make information provided misleading. They would credit assets received as gifts to a stockholders' equity account titled Paid-in Capital—Donations.