Market Value vs Investment Value

Understanding the concept of different types of values.

The market value of an asset refers to the price an asset would be sold for in the open market. It is also defined as the value the investment community assigns to particular equity or business.

Market Value Vs Investment Value

The market valuation of a firm overall refers to market capitalization (price x number of shares outstanding). 

It is considered easy to ascertain the market value of exchange-traded instruments such as stocks and futures as the market prices are widely disseminated and available to the public. 

However, it is slightly challenging to calculate the market value (MV) of over-the-counter instruments such as fixed-income securities. 

The main hurdle while calculating it arises when estimating the value of illiquid assets, like real estate or businesses. Such assets necessitate using real estate appraisers or analysts who are valuation experts. 

Market valuations of assets are considered to be dynamic. So it is because they heavily rely on assessing certain factors, ranging from the physical conditions of the economic environment in which the business operates to the demand and supply in the economy. 

It is determined from valuations of a company arising from calculations such as price-to-sales, price-to-earnings, enterprise value-to-EBITDA, etc. A higher value of such ratios implies a higher firm's market value. 

Ways to Express the MV of Assets 

The following are the different ways to represent the market valuation of an asset: 

1. Earnings per Share (EPS) – Earnings per share refers to the monetary value of earnings of an organization divided by the number of outstanding shares it's issued. EPS is calculated by dividing net profit by the number of outstanding shares.

It is considered one of the key measures to determine company profitability and is often used to calculate the market prices of stocks. 

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Calculated by allocating a specific part of the company's earnings to each stock, a higher earnings-per-share ratio signifies higher profitability. 

2. Book Value per Share (BVPS) – Book value per share refers to the value of equity remaining for the organization's shareholders. It is calculated by dividing total equity by the number of outstanding shares. 

A lower ratio implies that the firm is undervalued and vice versa. The book value of shares should, ideally, be lower than 1, as this indicates a highly undervalued firm. 

3. Market Value per Share (MVPS) – MV per share is the value that market forces assign to a given company's shares. It is calculated by dividing the total market value of the business by the number of outstanding shares.

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A market valuation higher than the firm's book value indicates that the market overvalues the firm as compared to its book value. 

4. Price to Earnings Ratio (P/E) – The price-to-earnings ratio informs the investor about the company's actual value. It is calculated by dividing the company's stock price by the earnings per share, usually over the past year. 

It indicates how much an investor will have to pay for each dollar earned by the firm in a year. No specific number conveys a good P/E ratio, but ratios below 15 are considered cheap, whereas those above 18 are expensive.

Different Approaches to Calculate MV

There are three different approaches that analysts adopt to calculate it: 

1. Income Approach – The income approach uses earnings and other values from the firm's profit and loss account and the cash flow statements. The two different methods under the income approach are:

Discounted Cash Flow (DCF) Analysis – Under this approach, the market valuation of an asset is an estimated present value of future cash flows of a particular investment. 

Calculations

It is calculated by discounting future cash flows from an asset/project to the present value. The discounting factor in these cases depends on the prevailing interest rate, risk in the market, investor expectations, etc.

  • Capitalization of Earnings Method – This method evaluates the stable, income-generating property and calculates the net operating profits accumulated over a given period by the capitalization rate

2. Asset Approach – The asset approach utilizes the fair values of assets and liabilities on the balance sheet of a given company. 

This method considers both current and fixed assets and intangible assets, off-balance sheet assets, liabilities, and unrecorded liabilities. 

The difference between the fair market value of assets and liabilities is known as the net adjusted assets of the organization. 

3. Market Approach – This approach focuses on the market forces of demand and supply, the economic cycle of the country, and other market factors affecting the market value of assets. The different methods under the market approach are:

  • Comparable Public Companies – A company's value can be determined by comparing the values of other firms operating at the same scale in the same industry and/or region. 

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After establishing a set of similar firms, different accounting ratios, such as EV/Revenue and P/E, can be evaluated to measure and compare the MV of other companies. 

  • Past Transaction – Under this market valuation method, prices paid for assets/similar companies in past transactions can be used as a reference to ascertain the market value. 

This method is most commonly adopted for merger and acquisition deals. It is essential to compare transactions of firms that are comparable (similar size and industry involvement).

Importance

The market valuation method is considered necessary by analysts due to the following reasons: 

1. Develop Pricing Strategies – Different firms adopt different pricing strategies. One firm might focus on minimizing costs and achieving profit objectives, whereas another might adopt a value-driven approach that uses market perception. 

This value-based strategy offers several advantages, as fair prices appeal more to the target market, turning them into loyal customers. 

2. Eliminates Uncertainty – Another advantage of market valuation is that it eliminates redundancy or uncertainty while determining the asset's value because buyers and sellers in the market have different perceptions of the product's price. 

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Buyers always aim to pay less for assets, while sellers desire to sell them for the highest possible profit. The valuation thus helps to determine the asset's fair value, i.e., the correct price at which the asset should be sold.

3. Ideal Target Market – The target market for a product can only be correctly identified if the firm is aware of the product's market value. Many companies adopting a value-based pricing strategy appeal to middle-income buyers and offer midrange prices. 

If the firm's product is high-end with superior quality, it will command a high market value and vice versa. 

Concept of Investment Value

Investment value, in simple terms, refers to the price an investor would likely pay to purchase a property/real estate or some other investment, such as shares. It is considered an asset's value based on all the factors that affect worth.

Investors analyzing the market tend to consider the investment value model to decide on the allocation of funds in different properties, keeping in mind their investment goals. 

These goals can be in the form of the return on investment they aim for to earn above-average returns. Some investors prefer capital appreciation over a long period, whereas others tend to enter and exit their positions quickly to make instant gains.

Investing

Thus, the value investment methodology is based on the investor's belief, depending on the investment strategy the investor aims to adopt. 

Based on the idea of investment value, confident investors tend to adopt an approach known as value investing, which entails investors choosing shares that trade at prices lower than their intrinsic value

Such value investors actively trade, assuming the market undervalues certain stocks. Those who follow these strategies believe that the market overreacts to certain news, resulting in price movements that do not relate to the company's fundamentals. 

Ways to Determine Investment Value 

Investors can use specific methods to ascertain a security's investment value. The methods are as follows: 

1. Discounted Cash Flow Approach (DCF) – This model uses cash flows generated by a project or security. 

In this method, cash flows are discounted to the present value to calculate the net present value (NPV), internal rate of return (IRR), and capital accumulation. Although these calculations can be flawed, the DCF method aims to reduce such uncertainties as much as possible. 

2. Direct Capitalization method – Generally used by appraisers, the capitalization method focuses on the income streams generated by property or real estate investments. 

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Analysts commonly use this method to determine the market and investment value of commercial properties and another real estate. 

3. Gross Rent Multiplier – This method calculates a property's investment value by multiplying the rent generated by the property in a given year by the gross rent multiplier (GRM). 

The value of the multiplier is determined by the prices of similar properties being traded on the market. The multiplier indicates the years it would take a property to pay for itself in gross rent. 

4. Cash on Cash Return Metric – This ratio is calculated by dividing the initial year's pro forma cash by the initial investment made by the investor. The ratio measures commercial real estate performance. 

This method enables firms and investors to analyze an investment's potential cash inflows over a given time period. 

5. Comparable Sales Mechanism – Such mechanisms are used by investors who compare sale prices of similar properties in the neighborhood on a per-unit basis, such as per square meter.  

Investment Value vs. Market Value 

Investment value, on the one hand, measures the potential value of an investment based on specific market factors. In contrast, an investment's MV indicates an investment's actual value affected by the forces of demand and supply. 

The market value uses an appraisal process, whereas the investment value of security takes into account the personal investment objectives of the investors, such as goals for the investment or the property needs of the investor. 

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The investment value can be both higher or lower than the security's market value and depends on the asset's specifications at a given time. Investment value is generally more significant than the MV if the buyer assumes a higher value than an informed purchaser. 

For example, a company will perceive a higher investment value if a larger property is put up for sale right in front of its office. They can expand quickly, making the property more attractive to them than other buyers. There is also a risk a competitor will buy the property, taking their business.  

In such a case, the company will agree to pay a higher price for the property.

On the other hand, investment value can be lower than MV when the investment is not the type of property that an investor would typically concentrate their efforts on. For instance,  a multi-family-home developer aiming to build a hotel will consider a lower IV.

An investment option can have a lower value than market value due to the high costs associated with developing the property or the demand for above-average returns by an investor.

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Researched and authored by Mehul Taparia | LinkedIn

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