Cost based valuation
Valuing an asset by what it would cost to build it from scratch today, rather than by its cash flows or the price of comparable assets — mainly used by strategic, not financial, investors.
In plain language
Most people who buy shares cannot build the company themselves. They have only one real choice: buy shares at the market price, or don't.
A strategic buyer — a company looking to actually run the business — has a second option: build an equivalent business from scratch. Cost based valuation compares the price of buying against the cost of building. The workbook is explicit that this makes the approach unsuitable for most stock market investors, who never have the "build" option in the first place.
How it works
The workbook sets out three broad approaches to valuation: cost based valuation, cash-flow based (intrinsic) valuation, and selling-price based (relative) valuation. It then rules the first one out for most of its audience: cost based valuation "often involves technical assessment by engineers and is seldom employed by financial investors," and the workbook itself moves on to cover only the other two in the rest of the chapter.
A worked example
A strategic investor is deciding whether to acquire an existing cement plant, or build a new one instead.
An existing 2-million-tonne plant is available for Rs 1,800 crore. Engineers estimate that building an equivalent plant from scratch — land acquisition, machinery, environmental clearances, construction — would cost Rs 2,200 crore and take three years.
On a cost basis, buying the existing plant at Rs 1,800 crore is Rs 400 crore cheaper than building an equivalent one, and saves three years. That comparison only makes sense for a buyer who could genuinely choose to build instead — a decision no ordinary stock market investor is ever in a position to make.
Why NISM asks about it
Chapter 10.4(i) sets out cost based valuation as one of three broad valuation approaches. Expect a question on which type of investor cost based valuation suits — strategic, not financial — and why the workbook says it is "generally not suitable for financial investors."
Common exam traps
- Cost based valuation is conceptually close to replacement value, defined earlier in Chapter 3.1.4 as the market value of recreating a firm's assets today — the two ideas overlap, but the workbook introduces replacement value as a balance-sheet concept in Chapter 3 and cost based valuation as a top-level valuation approach in Chapter 10.
- Do not apply cost based valuation to an ordinary equity investment decision — it requires the buyer to genuinely have a build-versus-buy choice, which a portfolio investor almost never has.
Where this is taught
Free preparation for NISM Series XVRelated terms
- Book valueA company's net worth — equity capital plus reserves — divided by its outstanding shares, the accounting value each share would theoretically get if the company wound up today.
- Discounted Cash FlowA valuation method that estimates the cash a business will generate in future years and converts each year back to what it is worth today.
- Relative valuationValuing an asset from the prices of comparable assets rather than from its own cash flows — quick, intuitive, and dependent on whoever set those comparable prices being right.
- Risk neutral valuationA cash-flow valuation method that adjusts expected cash flows for the probability of actually receiving them, then discounts the result at the risk-free rate — used mainly for insurers.
- Book Value approachThe first of the three asset-based valuation methods: value the company at the historical carrying cost of its assets and liabilities, giving a book value per share treated as the floor price.