Equity Valuation: Time Value of Money

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Valuation is the process of estimating the market value of financial asset or liability. Valuations are required in many contexts including investments analysis, capital budgeting, merger and acquisition transactions, financial reporting, taxable events to determine the proper tax liability and litigation.

Time Value of Money

The calculation of time value of money is important in the financial manager’s decision making process because the basic security valuation models are based on the idea that money has a time value. This means that a rupee received now is worth more than a rupee in the future. An individual would ready to invest a rupee only if he receives more than a rupee in exchange in the future. The time value of money concepts states that earlier receipts are more worth than later receipts because earlier receipts can be reinvested to bring additional return before the later receipt is generated.

The process of computing the future value, based on the initial amount, the interest per period and the number of years, is called compounding. Future value received after a stipulated year can be calculated with following compound interest formula:

FV = PV (1 + r)^n;

FV – Future value

PV – Present Value

r – Rate of interest per period

n – No of compounding periods

To calculate the present value of sum to be received in future by a reverse process known as discounting. The process of finding present value based on future value, the interest rate and the no of periods is known as discounting.

PV = FV / (1 + r)^n

The most theoretically acceptable stock valuation method, called income valuation or discounted cash flow method, involves discounting the profits (dividends, cash flow, earnings) the stock will bring to the stockholder in the foreseeable future, and final value on disposition. The discount rate normally has to include a risk premium.

Valuation process is centred on present value which is computed as discounted value of future stream of benefits. Valuation process is comparatively simpler in case of fixed income securities and preference share and is rather complicated in case of equity shares.