Market Value

Market value is the price at which buyers and sellers trade similar items in an open marketplace. In the absence of a market price, market value is the estimated highest price a buyer would be warranted in paying and a seller justified in accepting, provided both parties were fully informed and acting intelligently and voluntarily. This is the price that a willing buyer and a willing seller would pay if the transaction would be consummated today or in the near future. The market value of a stock is what it is trading for today. The problem with this form of value is that it may be based on a "market bubble". Market bubbles are over-valuations in assets based on irrational behaviors of investors. For example, many Internet stocks in the late 1990s were overvalued based on hype in the business community. Technology analysts saw great growth in market demand for the Internet by consumers and businesses. The bubble did burst as the hype did not transform itself into reality. The ability of the Internet companies to generate cash was in many cases nonexistent.

Analysts have created ways to rationalize the future growth in terms of market price by using the earnings multipliers. They use the following formula to understand value:

Market Value = Earnings Price/Earnings Multiplier

This equates the value of a company with its earnings and a multiplier. Another way to think about this formula is that the multiplier represents some premium that a buyer will pay over current earnings. The premium is in many respects an adjustment for the ability of a company to produce earnings and future growth. The major issue with the multiplier approach is that earnings are not a strong indicator of value and cash generation.