Valuation Why and How??

Ever wondered the how people assign value to various assets and transactions? or for that matter, why do people indulge in "Valuation"? Read ahead!

One of the first things that we learn as a school student, in our first brush with the idea called "Financial Management", is that "Wealth Maximisation is the first object or the supreme object of Financial Management". This overrides any other objective a Finance Manager could possibly have, and overrides all other objectives. In fact, every subsequent objectives in relation to Cost Minimisation, Investing Decisions, Optimum Capital Structure etc. ultimately are for the purpose of "Value Maximisation" or "Wealth Maximisation".

This effectively means, the performance of a finance management is measured against the wealth that he has created or maximized. This cannot be done unless we measure wealth. Wealth and Value are pretty much synonymous. 

Now that we are reasonably (hopefully) clear about "Why Valuation?", we can look at "How Valuation?" To be sure, "Value" isn't just some random "Opinion", as is often identified in the costing books, but some thing which can be objectively determined. Now to the question - How do we value an asset?

This is best understood with a set of examples. 

One. Lets say there are two residential properties. One located in the heart of a city (or one among many hearts for cities such as Chennai, Bangalore). And another one is located in some remote village, a far cry from civilization, and a couple of kilometres away from the nearest railway station, bus station, policy station, fuel station etc. 

Other things remaining same, and you remaining rational, would you pay more for the property in the heart of the city or for the one near jungle? The obvious answer should be "Yes". If it isn't yes, it is obvious that you aren't normal. You would never pay more for the one in the jungle. Why so? The one at Chennai has more facilities, more utilities, and therefore could fetch a "Higher Rent" or a "Higher Resale Price" or put it simply higher moolah. 

In this case, what influenced your assertion on the value? The potential future benefits measured in financial terms. The potential fat bank balance by choosing the one in the centre of the city, as against a potential flat zero balance for the jungle property. It is a different issue that you need a fatter pocket, fatter than your waist to buy a property even in jungle these days.

Two. You enter a garment shop. The sales lad shows you two denims. One from some bit ticket brand, and another some locally made stuff. The term "local" kind of puts you off. But still, you try to feel the quality of the denims by trying them out. With all the excitement, you try the big branded stuff. It feels great. You look at the price tag of around 5000 bucks. You feel okay. With very little expectation, you try the local stuff. It feels divine. Far better than the big brand stuff. You look at the price tag, and it reads 1000 bucks. And you look at yourself in the mirror in the trial room, you are all teeth. 

You come out of the room with various numbers running in your head, and you say to yourself "Local one is pure gold for what they offer. It is definitely worth more than Rs.5000. The big brand one is total washout. Not worth the money you pay."

At that precise moment, what made you place such a value? Would you have placed the same value for the local stuff had your expectation been sky high? 

What is that we can infer from the above two examples? Two things. One, higher the future benefits or economic benefits, higher would be the value we would place. Two, lower the expectation, higher would be the value we would place.

And that sums up the "How Part?". Future benefits and the expectation of the "valuer" are the two drivers of "Value" of any asset or transaction. Value today is a function of these two things. Mathematically, we express value as present value of future cash flows, where future cash flows are "Future Benefits", and the "Present Value" i.e. the discounting activity in financial management, is the expectation.

That ends this teaser on valuation.

Post credits : fundamine.in