Chapter 13: Valuation of investments

Question 1

What are the 8 main types of valuation methods?

SHAMFADS

Answer 1

S - Smoothed market value
H - Historical book value
A - Adjusted book value
M - Market value
F - Fair value
A - Arbitrage value
D - Discount cashflow model
S - Stochastic model

Question 2

Explain what is meant by market value and smoothed market value

Answer 2

Market value

• For a traded security, the market value is easily obtained and objective. However, it varies constantly and can only be known with certainty at the date a transaction takes place.
• Even in an open market, more than one figure may be quoted at any time (eg reflecting the bid/offer spread).
• If asset prices are not available, get the market value of a similar asset as a proxy

Smoothed market value

• Moving average of market value, this removes random fluctuations
• Removes volatility, but difficult to compare to a value of a liability

Question 3

What are the main problems with market values?

Answer 3

1. Market value can mean:
   - Yesterday’s value
   - Mid-day value
   - Net cost and taxes
2. Market impact - volatile
3. Difficult if the asset is unquoted

Question 4

Explain what is meant by historical book value and adjusted book value

Answer 4

Historical book value
- Refers to the price originally paid for the asset

Adjusted book value
- Reassessing book value upwards or downwards to be a closer match to market value

Question 5

Explain what is meant by fair value

Answer 5

• Amount at which an asset could be exchanged or a liability settled between knowledgeable, willing parties at arm’s length
• For assets, this is usually market value
• If not market value is available use:
• most recent or adjusted price,
• seek price from a broker,
• use a market consistent stochastic discount model,
• profit factor,
• accounting ratio

Question 6

Explain what is meant by arbitrage

Answer 6

• Obtaining a proxy value by calculating a replicating portfolio with a combination of other investments that result in the same cashflow and applying the condition that in an efficient market, if they have the same cashflows, they should have the same value
• Useful for derivatives

Question 7

Difference between a discount cashflow model and a stochastic model

Answer 7

A stochastic model is an extension of the discount cashflow model where the future cashflow and/or interest rate is treated as a random variable.

Results in distribution of cashflows with an expected value and a variance

Discount cashflow model
Discounting the expected future cashflows from an investment using long-term assumptions. Uncertainty in the cashflows can be allowed by having a higher discount rate.

Consistent with the basis used to value an investor’s liability. However, it relies on the assessment of a suitable discount rate, which is straightforward for some assets but less so for others.

Question 8

What are the most suitable methods to value bonds

Answer 8

• Market values (smoothed market value not very common)

* Discount cashflow

Question 9

List the steps on how bonds can be valued using a discounted cash flow

Answer 9

1. Look for similar bonds (similar credit rating, similar terms, similar marketability)
2. Yields on similar bonds can be good proxy for bonds
3. Expert can value based on judgement as market makers trade bonds all day and have a good idea of what is a good or bad value for a bonds

Yield can also be obtained from

1. Government bonds / higher quality bonds
   - Market spot rates, which is derived from the yield curve for zero coupon bonds
2. Corporate bonds / lower quality bonds
   - Adjust spot rates upwards for security and marketability
3. Bonds with otions
   - Black-Scholes or stochastic interest rates model

Question 10

What are the two types of bonds with embedded options?

Answer 10

1. Puttable bonds: Investors can demand payment at anytime

2. Callable bonds: Borrower can chose to repay at any time

Question 11

What happens when large amounts of illiquid assets are sold

Answer 11

Market prices move

Question 12

What are the most suitable methods to value equities

Answer 12

1. Market value (smooth market value)
2. Dividend discount model (stochastic possible)
3. Net asset value
4. Measurable key factor
5. Economic value-added

Question 13

State the general and simplified dividend discount models

Answer 13

General
V = sum(from t=1 to infinity) dt * vt

Simplified
Assume all dividends grow at a constant rate g and an interest i is payable annually
V = D/(i-g)

Question 14

What are the assumptions with the simplified model

Answer 14

1. Constant dividend growth of g and rate of return i into perpetuity
2. Ignore tax and expenses
3. Annual dividend
4. Shares are held into perpetuity
5. Dividends are reinvested as they are paid at a rate i

Question 15

Explain the economic value-added method to value equities

Answer 15

EVA = NOPAT - WACC * (net assets)

NOPAT = Net operating profit after tax
WACC = Weighted average cost of capital

According to CAPM (capital asset pricing model) if EVA is positive the managment is adding value beyond that expected in the efficient market

Sum of PV of future EVA + net assets = true value management is adding to the firm

Question 16

Explain the net asset value method to value equities

Answer 16

NAV per share = (net assets - intangible assets)/number of shares

Question 17

Explain the measurable key factor method to value equities

Answer 17

Finding some measurable factor of the company’s business and then comparing it to a similar company to arrive at a similar suitable factor to price the company’s share.

E.g., taking the market share of an unquoted company and applying a factor to that compared to a similar quoted company

Question 18

What are the most suitable methods to value property

Answer 18

1. Discount cashflow - formula in summary sheet

2. Fair value

Question 19

Why is market value not a good method for valuing property?

Answer 19

Property isn’t as actively traded as equity or bonds, moreover, no two properties are the same

Question 20

What are all the future cashflows from a property investment that would need to be discounted?

Answer 20

1. Rental income (monthly or quarterly)
2. Rent reviews (happens only every few years) usually only upward and in light of current market rents (rack rent) and inflation
3. Expenses and tax
4. Refurbishments
5. Future sale price

Question 21

What is the rack rent from a property?

Answer 21

Rent that could be achieved from the property if it was rerented on the open market today

Question 22

How is the discount rate decided on the property?

Answer 22

• Primeness of property
• Risk of property
• Expert opinion (surveyor)
• Government bonds + margin for risk

Question 23

What is a swap and an interest rate swap?

Answer 23

A swap is an agreement between two parties to exchange a series of payments for a specific period of time, according to a pre-arranged formula.

For an interest rate swap, the payments are specified as a percentage f a nominal amount.

Part A makes payments to Party B based on a fixed interest rate (fixed leg), and Party B makes payments to Party A based on a variable market interest rate (floating leg)

Question 24

What are the most suitable methods to value swap

Answer 24

1. Discounted cashflow model: PV(Income - Outgo)

2. Arbitrage: forward rate agreement for interest rate swap

Question 25

What are the main causes of inconsistency in market valuation?

Answer 25

Assets are valued using market discount rates (as there is a market for assets) and liabilities are valued using non-market rates (no market for liabilities)

Asset valuation is influenced by the actions of the asset manager, e.g., switching funds from bonds to equities

Question 26

How can consistency be achieved in valuation?

Answer 26

1. Use a smoothed market value
2. Using the same long-term stable interest rate in discount cashflow for assets and liabilities
3. Valuing liabilities in a market-consistent interest rate based on the expected return of the asset portfolio or some benchmark portfolio (e.g., taking return from a replicating portfolio of bonds and adding a margin)