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Discuss the drawbacks of using the following approaches in estimating a security's value: (i) Book value; (ii) Replacement value; (iii) Substitution value; (iv) Intrinsic value.

Discuss the drawbacks of using the following approaches in estimating a
security's value:
(i) Book value;
(ii) Replacement value;
(iii) Substitution value;
(iv) Intrinsic value.

Answers

Martin
(a) Book value – historical or balance sheet value
Book value of an asset is determined using the net asset basis/liquidating method
where, the value of a share i.e
Value of a share = Net worth (equity)___ = Total Assets – Total Liabilities
No. of ordinary shares No. of ordinary shares
The main weakness of the book value valuation is that the data used is historical.
Replacement Value:
Its based on the cost of replacing the existing assets. However, only the productive
fixed assets can be replaced at ago since current assets are circulating working capital.
Replacement value = Replacement Cost of Fixed assets
No. of ordinary shares
The problems with this value are:
(i) It is based on one portion of total assets.
(ii) Replacement value is subjectively determined.
Substitution value
This involves determining the value of a security by looking at the value of a
similar/substitute value of a share of a competitor company in the same industry.

The problems with this value are:-
(i) Firms do not have similar productive assets for the purpose of using one
security as a substitute of the other.
(ii) There are no two firms which are identical or similar in their operating
characteristics e.g firms in the same industry will have different accounting
policies and management styles.
Intrinsic Value
It's the value determined using historical information and financial models
e.g the dividend yield model.
The problems with this value are:
(i) It is based on historical data.
(ii) The models may not be accurate in fact different models produce
different intrinsic values.
marto answered the question on February 11, 2019 at 07:17

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