VALUATION THEORY
Chepakovich Valuation Model Valuation Basics Valuation of Banks Intrinsic Value
Intrinsic Value
Introduction Cash Flows Risk-Free Rate Assesment of Risk
Summary
This text describes the notion of financial intrinsic value and outlines methodology for its calculation. While the notion has long been used for investment analysis, the methodology presented here is quite unique and novel. Unlike other (older) methods, it has been developed to utilise power of the computer for analysis of historical financial statements and forecasting company's future financial performance. Also, due to its unique features and solid theoretical basis the methodology – which has become known as the Chepakovich valuation model – provides a reliable and comprehensive solution for diverse valuation needs and cases.
Introduction
The term 'intrinsic value' could be misleading. Everything has a value. This value is very person-specific and very often has nothing to do with monetary value. In fact, it is impossible to put a price tag on what is most dear to us – our family, friends, happiness, health, etc. In finance, however, the application of the term is very narrow: it only means today's monetary value. It makes possible determination of financial attractiveness of very different investments, as each of them can be described by just one number – the sum of money a particular investment is worth today. It is an indispensable and versatile tool of investment professionals.
The notion of financial intrinsic value (or simply 'intrinsic value', as we will refer to it throughout this text) should not be confused with 'fair value'. The latter term is tied to the notion of the highest price a buyer is willing to pay for a particular asset. In essence, it is very close to what is called 'market price', and in many cases – when there is a liquid and unhindered market for a particular asset – it is indeed equal to the market price.
On the face of it, calculation of the intrinsic value is very simple and straightforward. It can be split into three major components:
- Amounts of future cash flows
- Alternative investment opportunities
- Certainty of future cash flows
The first component is the amounts we expect (or, in the case of a bond, we are entitled) to receive in the future from a particular asset. The latter two components are needed to discount these cash flows to present.
Alternative investment opportunities provide a reference point for assessing required risk-free rate return, i.e. the required rate of return on investments where repayment of the invested amount and stated income/interest is absolutely certain. In principle, this risk-free rate can be different for different investors. In practice, however, it is usually equated with return on government bonds in the investor's home country. This stems from the assumption that governments cannot default on their domestic bonds because they have the power to create money and can always pay on their debt obligations, even if such payments will be with devalued money.
Certainty of future cash flows is a measure of risk. It quantifies the probability of future cash flows being what they are currently estimated to be.
Now let's consider each of these components in more detail.