Question

Why does the ‘valuation’ of a company play such an important role when determining the potential return of an investment opportunity? Please provide an example to illustrate your reasoning.

Answer 1

Valuation of a company will always be playing an important role in determining the total rate of return on investment because valuation of a company means that finding out the intrinsic value of the company and then comparing the intrinsic value of that company to that of the current market price of the company and accordingly deciding upon whether to invest into the company or not.

This type of investing is known as value based investing in which there is always a focus to find discrepancy between the price and the value of a security and these discrepancy are to be capitalised by the investors.

when the intrinsic value of the shares calculated is lower than the current market price of the share, then the shares are overvalued and value best investment will advocate for avoiding investment into those securities.

when the intrinsic value of shares calculated is higher than the current market price of the share then the shares are undervalued in nature, and the value based investment will advocate for investment into those shares to capitalise upon the difference.

For example it can be said that when calculation for the intrinsic value of the share is done by intrinsic value of Apple will come out at 400, and the market price of Apple is 300, then the shares would be purchased by the value based investor believing thatshare will have a upside in future because it is currently undervalued.

So it can be said that valuation is an important perspective of the investment and it is always a focus to capitalise upon the difference between the price and the intrinsic value of the share.