Valuation of cash flow produced by a valuable asset

Question

How should a cash flow produced by an asset of value (such as a stock or piece of land) be valued when the receipt of that cash flow is dependent on the ownership of such asset?

For example, consider a business that owns stock selling for $100 that pays an annual dividend of $10. The value of this business is obvious: $100. Now, consider a business that owns a piece of farmland worth $500. That farmland is used to operate a business that generates $200 per year in profit. To value this, we could add the value of the farmland ($500) to the terminal value of the cash flow ($200 / discount rate) to find the value of this business. This is presents a discrepancy in the way these two businesses are valued. In one, the cash flow is ignored. In the other, it is accounted for. I can think of similar situations where cash flows come from an asset with value such as with intellectual property (licensing fees). How are such situations handled?

Answer 1

I'm assuming you mean "a company that issues stock selling for $100". If that's the case, then the value of that stock must represent something, either assets or future cash flows.

There are many different ways of evaluating a company, and you've hit on two of them. One way is just to look at "current value", which is the value of all of its assets (minus its liabilities) at the current time, ignoring future cash flows. This is more common in a liquidation situation, where a company is being sold off for its pieces rather than seen as an "investment".

Another is to look at the company as a stream of future cash flows (income). Here the assets are not directly evaluated themselves, but rather seen as resources that generate the future cash flows. The value of the assets is seen more as a minimum value of a company should the prospect of future income dry up. They can also be used as a "terminal" value in a DCF model, but more commonly the company is assumed to exist in perpetuity, and so a "perpetuity" model is used treating the remaining cash flows as occurring forever.

This is how stocks are commonly valued - the value of a share of ownership is the prospect of future income, either through dividends, future income (increasing the value of the company if not distributed), or through acquisition. The current value of the assets is the "liquidation value" and treated as a minimum value, but the future income stream is considered provided it is above that minimum.

Answer 2

It is because they answer differently the question "What are you selling?"

Imagine a wealthy businessman who does all his work from his Toyota. His annual income might be a million dollars, but if you're buying just his Toyota, you might pay just $20,000 - a far cry from a million dollars.

If you bought his business, though, you might be willing to pay more than a million dollars.

In your examples, the $10/year dividend is priced into the $100 value for the business. However, if you buy the farmland, you're likely to be buying just the real estate, not the cows, employment contracts with the farm hands, and so on. If so, the cashflow generated by the farming business is separate to the value of the land.