The value of an asset is the present value of its expected returns. Specifically, you expect an asset to provide a stream of returns during the period of time you own it. To convert this estimated stream of returns to a value for the security, you must discount this stream at your required rate of return.
Estimate Expected Return
This process of asset valuation requires estimates of (1) the stream of expected returns and (2) the required rate of return on the investment.
An estimate of the expected returns from an investment encompasses not only the size but also the form, time pattern, and the uncertainty of returns, which effect the required rate of return.
The returns from an investment can take many forms, including earnings, cash flows, interest payments, or capital gains during a period. Analysts consider several alternative valuation techniques that use different forms of returns. As a example, one common stock valuation model applies a multiplier to a firm’s earnings, whereas another valuation model computes the present value of a firm’s operating cash flows, third model estimates the present value of dividend payments. Returns or cash flows can come in many forms, and you must consider all of them to evaluate an investment accurately.
You cannot calculate an accurate value for a security unless you can estimate when you will receive the returns or cash flows. Because money has a time value, you must know the time pattern and growth rate of returns from an investment. This knowledge will make it possible to properly value the stream of returns to alternative investment with a different time pattern and growth rate of returns or cash flows.
Require Rate of Return
The required rate of return on an investment is determined by
- the economy’s real rate of return, plus
- the expected rate of inflation during the holding period, plus
- a risk premium that is determined by the uncertainty of returns.
All investments are affected by the risk-free rate and the expected rate of inflation because these two variables determine the nominal risk-free rate. Therefore, the factor that causes a difference in required rates of return is risk premium for alternative investments. In turn, this risk premium depends on the uncertainty of returns or cash flows from an investment.