What is the significance of market value in the valuation of investments?

- Need a consistent valuation method for A/Ls to investigate relationship b/w A/Ls
- After establishing the market value of an asset (or a proxy to it), to ensure equivalence, a market-consistent method is chosen to value liabilities
- This method is used so that at least the asset valuation relates to observable data

(1) What are the different methods to valuing investments?

(2) What are the characteristics of each of these methods to be considered?

(1)

- Market value
- Smoothed market value
- Fair value
- Discounted cashflow
- Stochastic models
- Arbitrage values
- Historic book value
- Written up/written down book value

(2) C - Consistency with liab valuation U - Understanding ease R - Realistic V - Volatility E - Ease of calculation

O - Objectivity

Market valuation characteristics:

- Can only be known with certainty at the date a transaction in the asset occurs

Pros:

- Generally fairly easy to obtain (does not require calculation)
- Well-understood & accepted
- Objective value
- Realistic as realisable value on sale
- Can be used as comparison to other valuation methods to see whether an asset seems over/under-priced

Cons:

- Volatile mkt. values in short-term
- Difficult to ensure consistency of basis with that of Ls
- There may be no quoted prices eg direct property
- May not reflect value of future proceeds
- May not be realisable value on sale eg. dealing w large volumes or illiquid stocks
- Value reflects the position of the marginal investor (large institutions) rather than the individual (eg taxation)

Why may someone selling an asset NOT obtain market value for it?

- Market value in the sale contract may be defined as:

o Mid-market value

o Yesterday’s market value - Net proceeds from sale will be reduced by tax/dealing expenses
- Selling a large holding of the asset may depress mkt value
- Special rate may be obtained from a predator trying to take control of the company by buying a strategic block of shares

Smoothed market value characteristics:

- Avg. of mkt. values over a defined period to remove daily fluctuations (only if mkt values are available)
- Not suitable for consistency in liab. valuation
- Requires judgment for:

o Smoothing period to be used

o Simple avg./Weighted avg./importance to recent values

Fair value defn for assets/liabilities:

The amount for which asset/liability can be exchanged/settled between knowledgeable, willing parties in an arms-length transaction

- For most assets it is simply the mkt. price

Discounted cashflow (DCF) method of valuation:

- Involves discounting expected future cashflows from an investment using long-term assumptions
- Easily made consistent w liab. valuation basis
- There may be subjectivity in making assumptions for suitable discount rate (unless high quality, fixed-interest bonds)

Stochastic models method of valuation:

- Extension of DCF method where discount rate, CFs or both are treated as random variables
- Produces a distribution of results for valuations using chosen dbns of random variables (rv.s)
- Particularly useful to value future cashflows that are dependent on embedded options being exercised eg.

o Option to wind up in adverse financial situation - Consistency with liability valuation is achievable
- Results dependent on assumed dbns for rv.s - which may be highly subjective

Arbitrage value method of valuation:

- Valuation calculated by replicating the investment w combination of other investments on the market & applying the law of one price
- It is a proxy to market value typically used to value derivatives

Historical book value method of valuation:

- Price originally paid for the asset; often used for fixed assets in published accounts
- Objective value
- Conservative
- Well-understood
- However in most valuations this method has little merit since its historical (might be from 10 yrs ago)
- Cannot value liabs in consistently using this method

Written up/ written down book value

- Historic book value periodically adjusted for movements in value
- Subjectivity involved
- Cannot value liabs consistently using this method:

o Because appropriate discount rate to value liabs cannot be determined

How to value bonds:

DCF Approach:

- Govt. or similar high quality bonds valued by discounting CFs at rates consistent w mkt. spot rate yield curve (use zero coupon yields for different terms)

- Other bonds can be valued in similar way but discount rate should be adjusted upwards to reflect reduced marketability & lower security

How to value bonds with option features:

- Callable bonds: Investor can pay off bond at any time
- Puttable bonds: Investors an demand pmt at any time

To value a bond w an option feature:

- Add value of the ordinary bond without option and value of the option (calculated separately)
- Theoretically the option pricing techniques should be used to value option component

Methods for valuing equities:

- Market value
- Dividend discount model
- Net asset value per share
- Value added measures: Economic value added measure deducts cost of capital from one year’s profit to measure whether there was any value added
- Measurable key factors: e.g. for a food retailer with small margins, turnover per selling space or per member of staff is a measurable key factor

Market value method for valuing equities:

- Starting point for valuation of individual equity is the market value if there is a suitable market

Dividend discount model for valuing equities:

- Discounted value of the share’s future dividend stream

WHY USE IT?

- Can value unlisted shares
- Check whether the market value is reasonable or undervalued/overvalued

Assumptions of the dividend discount model:

- Dividends payable annually, next dividend payable in a year’s time
- Dividends grow at rate g per annum
- Required rate of return, i, is independent of the time at which the payments are received
- i>g
- Dividend proceeds are reinvested at i
- i and g defined consistently eg. both inclusive/net of inflation
- no tax & expenses

Issues to consider with the dividend discount model:

- Do not know what value of i to use in the model

o Assumption of constant i may not be appropriate in times of steep yield curve (sloping up or down)

o Discount rate might be long-term govt bond rate plus margin for riskiness of future income stream - Rate g is unknown

o Might start from IL govt bond yield & estimate real rate of dividend growth - Model ignores tax & expenses. The model should consider net dividends received & after-tax rate of return
- Model assumes annual dividend pmts even though they may be half-yearly on individual shares
- Model is useless unless i>g

Net asset per share method of valuation:

- Can be adopted for companies w significant tangible assets eg. property companies, investment trusts

Example :- Valuing investment trust shares using NAV/share method:

- Determine the mkt value of the shareholdings in the investment trusts & divide total value by the no. of shares for the investment trust company

o Frequently quoted at discount or premium to NAV per share

How to value direct property:

- Comparison to other similar properties that were recently sold as a point of reference

DCF APPROACH

- Consider whether the property is currently ‘over-rented’
- Consider whether the lease allows for downward rent reviews
- Consider the ‘stepped’ income stream
- Make assumptions:

o Rents payable in perpetuity monthly

o Rent reviews happen at times Ni, Nii, Niii …

o Rent quoted net of taxes/expenses

o Rent quoted net of refurbishing costs - Construct appropriate DCF model formula
- Use appropriate discount factor:

o Perhaps based on yield of a bond & margin for reduced marketability + risk + expenses

Factors to be considered when selecting discount rate for valuing property:

INTRINSIC FEATURES

- Size of property
- Quality of building eg. design, age, condition, access
- Nature of lease eg term, rent reviews, repair & insuring is the tenant’s responsibility
- Development potential of the property
- Comparability to other properties

EXTERNAL FEATURES

- Location
- Tenant quality
- Use of property

ECONOMIC FEATURES

- Macro/microeconomic factors such as oversupply or weak local economy
- Alternative uses for property to maintain rental if mkt. for the present use fails
- Prospects for rental growth

Valuing a swap:

- Value at inception to both parties of the swap = 0
- Both parties agree on future interest rates for diff. terms
- One party receives fluctuating pmts in line with LIBOR
- Objective is to find the series of FIXED pmts that would have the same PV as the predicted series of fluctuating pmts. at time 0
- We discount all cashflows using the yield curve agreed upon by both parties at inception
- Solve for the value of the fixed pmts required at each time point to equal PV(expected fluctuating pmts)

What are the different purposes for valuation?

- Regulatory purposes: Valuation basis may be prescribed in some cases and not in others.
- Discontinuance valuation: Valued assuming immediate wind-up

> Assets valued @ immediately realisable value

> eg. Pension scheme buying insurance to provide pension benefits - Ongoing valuation: Assumed that the fund is ongoing

o If liabs are viewed as a stream of future cashflows => DCF method more appropriate to value assets over mkt value method

o If liabs are valued at mkt rates of interest then mkt value of assets may be appropriate - Providing an update to management eg quarterly meetings
- Sale of business (M&A)

Comments on using market value method to value a portfolio vs DCF:

- If mkt value approach is used to value the portfolio, mkt discount rate should be used to value liabs (might be hard to determine)
- DCF method can more easily be made both stable & consistent with valuation of liabilities

Comments on volatility of asset prices wrt valuation:

- Volatility is not a problem in itself as it may reflect the underlying reality
- In the context of ongoing valuation for long-term fund, valuing liabs w stable interest rate could be misleading