Islamic finance, also known as Muslim financing, operates on principles that are fundamentally different from conventional (regular) financing. The core distinction lies in its adherence to Shariah law, which is derived from the Quran and Hadith, and governs all aspects of a Muslim’s life, including economic transactions. This difference of approach in financing naturally results in a divergence from standard valuation approach and methodology. Before this variance can be understood, however, it is best to recognize the dissimilarity between Islamic Finance and conventional finance.
What, then, are the sources of distinction between the two?
- Basis of Operation. Islamic finance is based on the principles and rules of Shariah, whereas conventional finance is governed by man-made principles.
- Concept of Money. In Islamic finance, money is a medium of exchange and store of value but not a commodity. It trades at face value. Conversely, conventional finance treats money as a commodity that can be traded at a price higher or lower than its face value.
- Risk and Reward. Islamic finance emphasizes risk-taking and risk-sharing. There is no pre-determined rate of return, and profit and loss sharing governs the relationship between capital providers and users. In contrast, conventional finance focuses on the elimination of risk and assures capital providers of a pre-determined rate of return.
- Economic Link and Social Responsibility. Transactions in Islamic finance are linked to the real economy, contributing directly to economic and social development. Conventional finance, with its focus on the financial economy, can lead to inflation, imbalances, and financial crises.
- Uncertainty and Speculation. Islamic finance prohibits excessive uncertainty (gharar) and speculation (maisir), aiming for win-win transactions and mutual benefit. Conventional finance often involves a great deal of uncertainty and speculation, such as in derivative contracts.
Valuation in Islamic Finance follows from its key features described above. Valuation in Islamic finance is unique due to its prohibition of interest-based (riba) transactions and the emphasis on asset-backed financing. Islamic financial instruments must involve risk sharing and comply with Islamic law, which influences valuation methods. For instance, in a murabaha contract, the price is marked up over the cost, reflecting the time value of the economic resources rather than the time value of money.
Islamic finance also rejects interest-based valuation techniques, and most Islamic scholars argue against interest rate benchmarking. Instead, valuation is often based on the asset’s underlying performance and the risk-sharing arrangement between the parties involved.
As a result, there is an emphasis on market approach and cost approach valuation rather than the more hypothetical income approach valuation. Income approach values under the Islamic Finance framework also tend to yield lower short-term returns as the Sharia-acceptable financial projections feature periodic profit-sharing payments rather than fixed annuities. However, the discount rate would typically be lower, reflecting 100% asset-backed financing. Moreover, the ultimate payout for investors is not necessarily low since they invest equity-like financing (partnership status) in companies and their assets. The practices support what was implied earlier, that because of the treatment of money and interest, there is a marked preference for using the market and cost approaches over the income approach.
In summary, Islamic finance offers an alternative to conventional financing that aligns with ethical and religious principles, promoting risk-sharing, social responsibility, and a strong connection to the real economy. Its approach to valuation reflects these principles, focusing on asset-backed, risk-sharing arrangements rather than interest-based transactions.
Written By: Roque M. Sorioso, Jr.
Aviso Valuation and Advisory Corp. is a real estate consultancy firm that offers valuation and business advisory services compliant to international standards such as the International Valuation Standards (IVS) and International Financial Reporting Standards (IFRS). To assure that we only produce high-quality deliverables, as needed, we do tasks beyond the usual appraisal process like verifying pertinent property documents (i.e. land titles, tax declarations, etc.) with the appropriate government agencies for due diligence purposes prior to the acquisition of the properties.
Sources:
(1) Difference Between Islamic Finance and Conventional Finance. https://fincyclopedia.net/islamic-finance/tutorials/difference-between-islamic-finance-and-conventional-finance.
(2) Differences Between Islamic and Conventional Financial Instruments. https://islamqa.org/hanafi/darulfiqh/156572/differences-between-islamic-and-conventional-financial-instruments/.
(3) Islamic Finance – World Bank Group. https://www.worldbank.org/en/topic/financialsector/brief/islamic-finance.
(4) A critical analysis of the use of fair value by Islamic Financial …. https://www.emerald.com/insight/content/doi/10.1108/JIABR-10-2013-0037/full/html.
(5) Major differences between Islamic and conventional finance – Ethis. https://ethis.co/blog/differences-between-islamic-and-conventional-finance/.
(6) 7 Differences between Islamic Finance and Conventional Finance. https://www.ad-ins.com/our-story/adins-story/7-differences-between-islamic-finance-and-conventional-finance/.
(7) Islamic Banking and Finance Definition: History and Example – Investopedia. https://www.investopedia.com/terms/i/islamicbanking.asp.
(8) Difference between Islamic Banking and Conventional Banking – AIMS. https://aims.education/study-online/difference-between-islamic-banking-and-conventional-banking-system/.
(9) An Overview of Islamic Finance; by Mumtaz Hussain, Asghar … – IMF. https://www.imf.org/external/pubs/ft/wp/2015/wp15120.pdf.
(10) Islamic Finance – Principles and Types of Islamic Finance. https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/islamic-finance/.
