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What is the concept of valuation in finance?


The concept of Value.

Every asset has a fair value which would be different from its market price. The market price of any asset purely depends on the changes in demand and supply equation and need not reflect the true value of the asset. Hence it becomes important for an investor to find out the approximate fair value of an asset before investing in it.

One simple rule in investing is that an asset should be bought when it is available at a bargain so that in future, when the asset gains in value, the profits you make is high. The question is, what’s the basic process to know an asset’s true or fair value? The answer lies in a process called valuation.

To put it straight – valuation is an attempt to know what an asset is ‘really’ worth. All assets like gold, land, villas and apartments, arts, antique pieces, shares, bonds, mutual funds or even cars and electronic items have to be valued so that you have a reasonable estimate of what you’re going to get for the money you pay.

In simple words , like many other things,  investments we make should also have a value for money approach.

Is it a new concept?

Valuation is not a new concept. We do a lot of valuation in our daily lives.  Let’s take the example of a couple who wants to buy a new villa. How would they know if the offer price of the villa is right? The solution is to approach a registered property valuator who will visit the site put the right price tag for it. Then, find out how much others have paid for similar properties in that area. Buy it only if the price quoted approximately matches with the valuator’s opinion. Lower the price, better the bargain.

Is it possible to value any asset?

Yes. It’s possible. It’s practical too. The level of knowledge required to value an asset depends on the asset type and your knowledge about the particular asset.

All assets types are not easy to value. Some may require an expert’s help or opinion.  Different methods are used to value different assets – for example the method used to value a property is entirely different from the method used to value mutual funds. Whatever be the valuated figure, remember that it is still based on certain estimates and assumptions. Hence, valuation itself is not fool proof. There will be an element of uncertainty in value estimates.

Why valuation is the core?

  • Asset prices are prone to overvaluation as the demand for it increases.
  • These overvaluations can continue for many years and one day, it will eventually burst and cause the price to fall lower than its fair value. We have already witnessed this scenario in stocks and real estate 2007-08.
  • High demand is only one of the reasons for over valuation. Asset prices will be inflated if there is excess money in the financial system, high speculative activity, reckless lending by banks, low interest rates etc…
  • Herd behavior or the tendency to follow what the crowd is doing is also another reason why over valued assets are traded in the market.
  • In a bull market (for any asset in general) investors ignore valuation and concentrate on the trend of price movement. They chase prices and focus on the possibility of resale of the asset. When they see the trend of rising prices, they buy those assets in hope of profiting from the increase in value.
  • It’s just like gambling at casinos. The game goes on and on and someone, at the end, will lose all his money.

In stock and commodity markets , traders buy assets at a higher price hoping that it can be sold to the next highest bidder. Their analysis may be based on technical factors like demand and supply or any other basis like trend or oscillators. Whatever it is , their actions are always risky as long as it doesn’t confirm with the fundamental valuations. History tells us that every time after a boom the prices have corrected back to its fundamental levels.

Hence, be it shares or mutual funds or property or currency- irrespective of the asset you choose to invest, buying decisions should be based on valuation or else, you will end up buying the assets at the wrong price.

General indications to know if an asset is overpriced.

General indications that an asset market has started getting overvalued is when-

  • Everyone is interested in the asset. There’s so much of hype around it.
  • There are many first-time investors entering the market.
  • Everywhere you observe people talking about the same asset.
  • There’s a lot of  stories circulating around like – the story of a taxi driver who made a killing from the market or the story of an employee who resigned to take up investing as a full time profession and made millions.
  • There’s a lot of warning bells ringing around, but no one cares to listen and the asset price keeps going north.

Key ideas: 

  • Valuation is the key to investing in any asset.
  • Valuation is based on assumptions and estimates.
  • Since valuation is based on certain assumptions, projections and past data, investing after finding the right value has a lot of risk attached to it. Imagine the risk of investing without valuing the asset.


One response to “What is the concept of valuation in finance?”

  1. Augustin K says:

    Thank You. it’s fabulous

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