Understanding Basic Valuation Rules and Concepts
Should an investor understand the valuation process?
Financial decisions made today will influence your emotional and financial comfort for years to come.
If you work with experienced investing advisors, or if you do your own investigations, you should understand the valuation process. After all, it’s your savings and your future financial security being put at risk when making any investment. The goal is to maximize your wealth and income and minimize your losses.
Failing to understand the valuation process will lead to sub-optimal decisions and impede your ability to live well in the future. Lack of understanding the basics will cause losses.
What are the key investing concepts and rules to follow?
Estimating the future cash flows expected over the life of the asset is a primary goal. The goal of investing is to increase cash-flows; the cash-flows can come regularly, or sporadically, or at the end of the holding period, but they must come eventually or the investment is unsuccessful.
Estimating the risks related to investment is a primary goal. Every investment carries risks; there is no risk-free investment. The challenge is to identify the risks, quantify them, and put a numeric value on them. The goal of investment risk-taking accepts only those risks that will allow you to “sleep well and have minimal worry”. Investing should be a comfortable activity, not a fearful one.
Estimating the present value of the investment is a primary goal. After determining the anticipated cash-flows and the related risks, assigning a value (price) is next. Buying a high quality asset at too high a price results in a disappointment. Buying an average asset at a low price results can result in a successful investment. Overpaying is one of the most common investing errors; not accurately estimating the present value of an asset is a danger.
Why are promissory notes discounted in value?
The market price of a promissory note is not always in agreement with its face amount.
The price of a note may differ from its par value or face value due to several factors:
1) Its interest rate may be less than the appropriate market rate.
2) Its cash-flow may be erratic or unpredictable
3) Its risks may be too great or too unpredictable
4) Its potential for default may be too high
Conclusions
• Investors punish risk by reducing or discounting the price of a promissory note
• Cash flow is king because the value of all financial assets is based on the cash flow
• Insufficient or poor information (garbage in) causes a discounted valuation
• Numbers don’t lie because they remove personal emotion from the investing decision
• Patience pays off because time is on your side if you select a good investment
Comfort is the most common-sense, and perhaps most effective, way to manage risk. If you look at your positions and cannot handle the stress, you are probably taking on too much risk. Only by understanding the level of risk with which you are comfortable can you determine how to invest.
