The Basic Financial Asset Valuation Model states that:
Thank you for reading this post, don't forget to subscribe!- The value of any financial asset is equal to the present value (PV) of all future cash flows that the asset is expected to generate.
This is the fundamental principle used to determine the fair value of stocks, bonds, and other securities.
- The value of a financial asset such as common stock, bond or preferred stock is based on the expected cash flows the asset will generate for the owner during the life of the asset or holding period.
Where:
- CFₜ = expected cash flow at time t
- r = required rate of return (discount rate)
- t = time period
- n = total number of periods
Meaning of the Model
- A financial asset (share, bond, etc.) has value because it provides future benefits, usually in the form of dividends, interest, or sale proceeds.
- These future benefits must be discounted to present value, because money today is worth more than money tomorrow.
- Investors use this model to decide whether an asset is overvalued or undervalued in the market.