Before understanding the difference between the market value and replacement value, let us revise their basic definitions.
What is market value
Market value is defined as the price at which the share of a company can be brought or sold on real time. It is the value of an asset in the marketplace. Market value is the same as market capitalization in the context of businesses.
The price required to buy one share of the company is the market value. On the other hand, if the investor needs to purchase all the shares of the company, it is termed as the market capitalization.
The current price of any stock depicts its market value.
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What is replacement value
Replacement value of a company is defined as the value at which a similar company, with the same fundamentals, assets and profits can be created at the very date.
Replacement value represents the market worth of all the company’s assets at any one time.
When an investor decides to set up a similar company with the same number of assets, infrastructure and profit growth, he uses the replacement value to arrive at the valuation. This is a value at which the current company can be replaced.
Here are 6 major differences between market value and replacement value
Difference in terms of price fluctuation
Market value is largely dependent on the market participants. This value is decided by the people in the stock market. The major drivers for the market value is the type of demand and supply in the market.
This demand and supply makes the price fluctuate on the daily basis. Thus, the market value of a company does not usually remain stable.
On the other hand, replacement value is arrived by calculating all the present assets, the cost of infrastructure and all the tangible factors that contribute in the fundamentals of the company. This also includes the cost associated with machinery, patent rights and special makes the company uses in its day to day operations.
The replacement cost is a fixed value as it is dependent on the underlying worth of the assets.
The price dependency factors
The major difference between the market value and the replacement value is the price dependency.
The market value is largely dependent on many external and internal factors of the company and economy at whole. The demand and supply of the shares mainly drives this value.
The following are the factors on which the market value of the company primarily depend:
- Psychology of the market participants
- Brand value of the company
- Economy of the country
- Fundamentals of the country
- Performance of the sector
While, the replacement value is a calculated value that is arrived by summing up the current value of assets and the price required to set up a same venture considering present conditions.
The following are the factors on which the replacement cost of a company depend:
- Assets of the company
- Cost of machinery and patent rights
- Intangible assets and brand value
- Yearly profits made my the company
- The cash reserves
- Research and development
Difference in terms of intent of the value
Market value is defined as the value that shares of a company can be brought / sold at real time. This is the price at which the shares of an existing company can be purchased by any investor.
Is is also the current price at which the buyer has agreed to buy and the seller has agreed to sell. It maintains the liquidity of the shares on the stock exchange.
Replacement value is the value that will required to set up a similar company considering the present market conditions.
Here, the investors are not considerate about buying the company, but creating another company of the same fundamentals, at the present scenario.
Creating a similar company requires much more capital than its actual value. This is because, the companies have reached at their peak performance with the passing of time and gaining experiences. Thus, meeting the expectations and performance comes with an added cost.
Relation with the demand and supply of shares
Market value is majorly dependent on the demand and supply of shares in the market.
If the demand of the shares of a company rises, the market value will rise. While if the demand for shares fall, there will be excess of supply, thereby causing the price to fall.
On the other hand, replacement value is gained with time. It has no relation with the demand and supply of shares in the market. It is purely based on the fundamentals of the company.
Comparison with intrinsic value
The demand and supply of shares determine the market value of the company. Market participants make illogical judgments as these factors are heavily impacted by people’s perspective about the firm, the current news floating around the company and the overall economy of the country.
A company with good fundamentals can still trade at a market value much lower than its intrinsic value. While, a company with poor fundamentals can traded ten times its real value.
For short term, the market value will not be justifying the intrinsic value of the company. But during the longer course of time, it will follow the fundamentals and its actual value.
The amount of the company’s assets, as well as the returns and profits it generates year after year, is used to determine the replacement value. This value does not change on daily basis.
The replacement value will always be equal to the company’s intrinsic worth.
Dependence on the fundamentals of the company
When considered on the short duration, the fundamentals of the company will not directly impact the market value. It is a gradual process for the market value to get in sync with the true value of the company.
While, the replacement value is majorly dependent on the fundamentals of the company. A company with good fundamental backbone, a strong balance sheet and large assets will contribute to the positive sides the replacement value
In the end, the investor must decide whether to stick with the company’s market value or calculate the replacement value and start a new business.
When the current market value of the company is much lower than its intrinsic value, buying the company makes a better option. On the other hand, when the market value is much above the true value, the replacement of the company can be more feasible.