Finance and Accounting for Nonfinancial Managers: All the Basics You Need to Know

By William G. Droms | Go to book overview

15
Valuation of Financial Assets

CAPITALIZATION-OF-INCOME METHOD

A financial asset may be defined as a security, such as a share of stock or a bond, that establishes a claim against the future income or assets of the issuer. In financial terms, the value of any financial asset depends on the earning power of that asset. In particular, the value of a financial asset may be determined as the discounted present value of expected future cash flows earned on that asset. This widely accepted valuation method, called the capitalization-of-income method, is conceptually straightforward and intuitively appealing.

It is necessary to focus on two areas of concern in applying the capitalization-of-income method. The first concern is determining the appropriate earnings to be capitalized; the second is determining the appropriate capitalization rate. This chapter will address the problems of valuing bonds, preferred stock, and common stock. The valuation principles developed in this chapter also can be applied to virtually any other type of asset, including real assets such as real estate, oil and gas drilling ventures, and closely held businesses.


SELECTING APPROPRIATE CAPITALIZATION RATES

Selecting an appropriate capitalization rate for valuing a financial asset is analogous to selecting an appropriate discount rate for capital budgeting purposes. The first step is to define the appropriate capitalization rate (K) as the minimum rate of return necessary to induce investors to buy or hold a given financial asset. Stated alternatively (and equivalently), given the risk characteristics of a particular

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