Chapter 13 - Valuation of investments Flashcards
List the main methods for valuing investments.
Market value
Smoothed market value
Fair value
Discounted cashflow
Stochastic models
Arbitrage value
Historic book value
Written up and written down book value
Discuss the use of market value to value investments.
Market value is often used as a reference point for other valuation methods
Varies constantly and is only truly known when a transaction takes place
Often a proxy for market value is used, especially for assets not traded regularly.
Trend is to use market value of assets and then use market-consistent valuation for liabilities
Advantages:
- generally easily available
- objective
- well understood
Possible issues with using market value:
- Volatility of market value
- Achieving consistency with valuation of liabilities
- Not available for all asset types
- May not reflect value of future growth and proceeds
Discuss the use of smooth market value to value investments.
Take some average of market values over a specified period to smooth effect of short-term fluctuations
One problem is this method does not lend itself to consistent liability valuations
What is the main principle when valuing assets and liabilities.
Consistency of valuation
Discuss the use of fair value to value investments.
Fair value is a market-based method of valuation used for financial reporting
Defined as the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties at arm’s length
Simply the market price for most assets
Other possible ways of obtaining the fair value:
- Seek price from broker or market-maker
- Adjust most recent known price in line with the movement of an appropriate index
- Use stochastic asset model to determine market consistent value
Discuss the use of discounted cashflow models to value investments.
Involves discounting the expected future cashflows from an investment using long-term assumptions
Easily made consistent with valuation of liabilities
- Use same approach to determine discount rate
Determining a suitable discount rate is not always simple, but is essential.
Discuss the use of stochastic models to value investments.
Extension of discounted cashflow models where future cashflows and/or interest rates are treated as random variables.
A distribution of values results, which can be used to obtain various statistics and confidence intervals.
Especially appropriate in complicated cases where future cashflows are dependent on the exercise of embedded options
Advantages:
- Good for valuing derivatives
- Obtain useful statistics and confidence intervals
- Consistency with liability valuation is also achievable
Disadvantages:
- May be too complex for many applications
- Usefulness of results depends on appropriateness of distributions for the variables
Discuss the use of arbitrage value to value investments.
Proxy for market value is calculated by replicating the cashflows of an investment with a combination of other investments and applying the condition that in an efficient market the values must be equal.
Often used in valuation of derivatives, as well as futures and options
Difficult to replicate many assets and so has limited usage
Discuss the use of historic book value to value investments.
Price originally paid for the asset
Advantages:
- Objective
- Conservative (unless asset values have fallen)
- Well understood
- Used for some accounting purposes
Disadvantage:
- Has little merit since it is historical
- Does not lend itself to consistent valuation of liabilities
Discuss the use of written up or written down book value.
Historic book value which is adjusted periodically to account for movements in value
Adjustment may be influenced by market value or discounted cashflow value
Disadvantages:
- May still not reflect the true market value accurately
- May require subjective judgment
- Does not lend itself to consistent valuation of liabilities
Read through section 3 on market values
Advantages and disadvantages of market value as a measurement
Argument that it obscures intrinsic value
Implications of using alternative to market value should be explained to potential clients
Conclusion that no method is necessarily better than others
- Context is most important
Discuss methods for valuing bonds
DCF
- Can be used for good-quality bonds, i.e. low credit risk with stable interest payments
- Discount rate is rate consistent with market spot rate yield curve
> Derived from ZCB yields and/or government bond “strips”
- Corporate or other high-risk bonds can be valued similarly with adjustment to discount rate to reflect lower security and marketability
Valuing bonds with option features
- Such as callable and puttable bonds
- Should theoretically use option pricing techniques
> Value of callable/puttable bond = value of vanilla bond + value of call/put option
> Call option has negative value to investor, while put option has positive value to investor (opposite for borrower)
Discuss methods for valuing equities
MARKET VALUE
- Typically the starting point
- Most appropriate the more efficient the market is
DIVIDEND DISCOUNT MODEL (DCF)
- DCF appropriate when
> shares unlisted and have no current market value
> want to check whether market value seems reasonable - After several assumptions
> share value = D/(i-g) OR
> share value = D0(1+g)/(i-g) - Selection of i and g
> i (normally) = yield on long-term government bonds + appropriate adjustment for marketability risk and volatility of dividends and capital value
> g (normally) = yield on long-term index-linked government bond + estimated real dividend growth rate - Issues with this simplification
> Choice of i and g is largely subjective and constant i over time likely inappropriate
> Very sensitive to size of i-g
> Ignores tax and expenses
> Dividends may be paid more/less frequently than annually, or not at all
> Model is useless if i < g
NET ASSET VALUE PER SHARE
- NAV = Total tangible assets-Liabilities
- Share price = NAV/no. shares * suitable ratio
> ratio could be derived from other companies (e.g. average of market value/NAV per share of appropriate companies)
- Tangible assets are assets which would retain their value if the company was wound-up
- Appropriate for companies with large tangible assets, e.g. property investment company or investment trust
VALUE ADDED MEASURES
Shareholder value
- attempt to get intrinsic value of investment
Economic Value Added (EVA)
- EVA = profit - cost of debt
- Share price = EVA * suitable ratio
- Positive value of EVA indicates value has been added for shareholders
OTHER METHODS
- Can use key ratios or factors to determine approximate share value
- Factor or ratio used will depend on company
Discuss methods for property valuations
Difficulties:
- Market value observed infrequently
- Considerable skill required to assess market values
- Valuations largely subjective
Considerations to make when valuing property:
- Indications of value can be taken from recent transactions of similar properties
- Can use DCF, but more common to use market-consistent or fair value
- Allowance needs to be made if passing rent (i.e. current rent) is different from the rack rent (open market rental value)
> Next rent review will lead to change to open market rent level if lease agreement allows this (i.e. what are limits on increasing/decreasing rent) - Discount rate should reflect riskiness of investment (what return is required)
> Could be based on bond yield of suitable term
> Adjusted for increased risk and marketability issues
> Property characteristics determine risk (see relevant factors p.19)
Discuss methods for valuing options, futures and swaps
Principle of efficient market and no-arbitrage is important
Option pricing techniques
- Based on replicating portfolio methods
DCF
- Value of swap will be 0 for both parties at inception
- See necessary assumptions p.20
- Discount rate extracted from appropriate yield curve
Alternative is to value swap as total of a series of forward agreements
