Asset Valuation Theories

Predicting future events is intrinsic to investing. All investment returns, be it for real estate, diamonds or stocks are dependent on this to a large degree. This is what makes investing a gamble and so exciting to investors at the same time. It requires a firm understanding of economic and political trends, industry research and that 6^th sense, gut feeling, investors intuition or whatever you want to call it.

The two theories used he most for asset valuation are the Firm-Foundation theory, which focuses on determining the intrinsic value of a stock and then basing buying/selling decisions on deviations from it. And the Castle-in-the-air theory, which uses charts based on new trends and mass psychology especially to make buying/selling decisions.

Let’s take a closer look at each theory.

The firm-foundation theory attempts to determine a stock’s intrinsic value by analyzing present conditions and future growth expectations. The theory stresses that a stock’s value should be based on the stream of earnings a company will be able to distribute in form of dividends in the future. The analyst must estimate long-term growth rates and how long the growth can be expected. Thus, the greater present dividends and their rate of increase is, the greater the value of the stock is as well.

Once the intrinsic value of a stock has been determined, it becomes a matter of the present stock value being above or below the intrinsic value to either sell or buy respectively.

The most successful follower of the firm-foundation theory is Warren Buffet (also called “The Sage of Omaha”), who has used this value-based theory of investing to become the second richest man in the world.

The castle-in-the-air theory on the other hand focuses more on psychological principles such as mass psychology versus financial evaluations of the stock market. It studies how the crowd of investors will likely behave in the future and how during periods of optimism they tend to build their hopes into castles in the air. In order to be successful an investor must estimate what investment situations are most susceptible to public castle-building and then buying before the crowd does.

One strong proponent of this theory and very successful investor was John Maynard Keynes. He may be mostly familiar to those who studied economics as the author of ‘The General Theory of Employment, Interest and Money’ and as one of the most influential economists of the last century (he is considered to be one of the main founders of modern theoretical macroeconomics). Fact is though that he used the castle-in-the-air theory to amass a personal fortune of several million pounds (measured in 1930’s and 40’s pounds).

In the end, both methods have their value and share of success and failure stories. A thorough analysis of a company’s present value, cashflow and future expected growth as well as it’s industry’s growth is certainly important. It allows the investor a conclusion based on facts and educated estimates.

On the other hand, understanding the psychology of crowds, buying crazes and bubbles such as the internet tech bubble of the late 90’s could lead to windfall profits. However it is all too easy to be swept away by the excitement and unfounded optimism of the crowd, missing a well-timed exit point and losing along with everyone else.

Studying these theories is well worth it to gain a better understanding of the stock market or any other investment vehicle.

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RE: Asset Valuation Theories 2007-07-18 14:59:03
   You hit the nail on the head with this article Kai. My own investment philosphy involves both a value investing approach, being having an understanding of a calculated present value and then determining if the current price is overvalued, fairly valued or undervalued. The second side of my investment idealogy comes from cycles and demographics. I've been bullish on stocks and a general asset bubble since 2003. I believe since then and to this day that based on cycles and demographics, we would have a great bubble in stocks that would peak in or around 2009. We're now more than half way through 2007 and stocks are once again the hot place for money to be. Cycles and Demogrpahics would have told you that housing prices and starts would peak in or around 2005 and decline for a long period of time, I'm guessing the house bubble will finish bursting around 2013. Stock have been rising for good reason. Valuations compared to other assets, a golden age in the global economy, weak US dollar and relentless US consumer. Having the awareness of both being able to determine a fair present value on a company along wiht knowing that we are in a time of Asset bubble mania has helped me greatly allocate money for myself and my clients. Visit my website for informantion on my upcoming classes and events. www.tillbergcapital.com - Tom Tim