Defining the Value of an Investment

When evaluating which investments to add to or subtract from your portfolio, one factor that might influence your decision is whether a particular stock, bond or fund seems like a good value. But there are many ways to define the value of an investment, and these can vary based on the type of investment product you're considering.

Here are some common methods of measuring value:

Market Value

Market value is the price buyers and sellers agree to pay or accept for a security at any given moment in time. For stocks and exchange-traded funds (ETFs), market value is a component of market capitalization (or market cap), which is simply the current share price multiplied by the number of outstanding shares.

For bonds, market value can be above or below par value(the amount a bondholder receives at maturity) based on interest rate levels, the perceived financial health of the issuer and supply versus demand.

Book Value

When talking about stocks, book value is the accounting value of a company: total assets minus total liabilities. Also called shareholders' equity, it represents the theoretical net proceeds if the company were liquidated (assets sold off and liabilities paid) that day.

Investors trying to identify undervalued stocks often look at price-to-book (P/B) ratio, which is the company's current stock price per share divided by its book value per share. A stock might be considered undervalued if it's trading below its book value (P/B less than 1). Keep in mind, though, that there can be other underlying reasons why a stock might trade below its book value. For example, the perception of weakening business prospects or the risk of significant lawsuits could send a stock price lower without affecting book value. Also, this metric is most useful when comparing similar companies, especially in asset-heavy industries like real estate and utilities. Book value is less meaningful for companies with valuable brands or intellectual property, as these intangible assets -- which in some cases make up the bulk of a company's market value -- are often excluded from the calculation.

For bonds, book value is mainly an accounting concept used by institutions and isn't typically relevant for individual investors.

Enterprise Value

Enterprise value (EV) is a measure of a company's total value--going beyond just equity. EV represents what it would cost to buy and take control of an entire company. You calculate EV by taking the market value of all the company's stock, adding all of its debt, and subtracting the cash it has on hand.

EV is used in ratios like EV/EBITDA (earnings before interest, taxes, depreciation and amortization) for more complete valuation comparisons than you get with a traditional price-to-earnings (P/E) ratio, which is the current stock price divided by earnings per share. One main benefit of using EV is that it helps you compare companies with different debt levels. EV is more comprehensive than market value since it provides a holistic picture of a business as it accounts for a company's debt load and excludes cash.

Intrinsic Value

This is an estimate of what an investment is "truly" worth, regardless of its current market value. Intrinsic value is based on fundamentals like earnings, assets, cash flow, growth prospects and interest rates and is an important component of valuation models and many analyst forecasts.

Intrinsic value is more subjective than many other valuation measurements as different investors and analysts can assess the components differently. Nevertheless, intrinsic value is a central factor in value investing: It establishes the benchmark by which you decide whether a stock or bond is currently undervalued, overvalued or fairly valued.

Par Value

Par value is the face value of a security set by the issuer. For common stocks, par value is mainly a legal and accounting concept that's unrelated to the stock's trading price. For bonds, par value is the amount that the bondholder receives at maturity. A bond's price compared to par value helps determine your rate of return. A bond trading at a premium (above par) offers a return lower than the coupon (stated interest rate), while a bond trading at a discount (below par) provides a return above that rate.

Yield

Yield reflects how much income you'll earn on an investment without having to sell it. It's the equivalent of interest. Many bonds are quoted based on their yield, with the most common calculation being yield to maturity, which tells you your total return if you hold the bond until it matures. For most bonds, the interest payment amount is set ahead of time and remains constant throughout the bond's life, but there are exceptions, such as variable rate bonds. Yield is a core component for valuing bonds.

Yield can also be a relevant metric for some stocks and funds. It's calculated by dividing the yearly dividend rate by the current price. Dividend yield is added to capital gains (or losses) to determine total return of a stock or fund. However, not all stocks and funds pay dividends.

For bonds, stocks and funds, the yield changes as the security's price fluctuates. Typically, when a security's price rises, its yield falls; when its price falls, its yield rises. Yield also changes when a stock or fund raises or lowers its dividend.

Net Asset Value

Net asset value (NAV) -- used for mutual funds and ETFs -- is the per-share value of the securities the fund holds. Trading differs for open-and closed-end funds. Open-end mutual funds are bought and sold at their NAV, so the day's NAV reflects the price for all daily transactions. Closed-end funds trade in the marketplace based on supply and demand and usually are priced at either a discount or premium to NAV.

Using Valuation Measurements

Looking at multiple measures can provide a fuller picture of investment value than a single valuation method or metric. And context also matters. Different industries have different "normal" values: Tech companies usually have higher valuation metrics than utilities, for example.

In addition, rather than looking at a company's metrics in isolation, compare the current metrics to the company's historical values and industry averages. Beware of value traps, where a security seems undervalued but might have sold off because investors perceive a deterioration in its business not yet reflected in revenue, earnings, book value or other metrics you're using.

Some funds invest based on specific value metrics, which you might be able to use to support your preferred investment strategy.

Keep in mind, though, that valuation is both art and science. Numbers matter, but so do qualitative factors like management competence and competitive advantages. And just because a security is regarded by other investors as a good value doesn't mean it's a fit for your portfolio. Consider working with an investment professional to determine how best to achieve your financial goals.

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