CH: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 fair value

Answer 2

• 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 no market value is available use:
• most recent or adjusted price,
• seek price from a broker,
• use a market consistent stochastic discount model,

Question 3

What is the advantages of market value vs calculated values

Answer 3

• objective
• realistic
• easy to obtain
• well understood and accepted
• can be used as a comparison to other valuation methods to see whether an asset is under- or over-priced

Question 4

What is the disadvantages of market value vs calculated values

Answer 4

• may not be readily obtainable (e.g. unquoted instruments)
• volatile values may fluctuate greatly even in the short term
• may not reflect the value of future proceeds
• a decision is required about whether bid, mid or offer prices should be used
• difficult to ensure consistency of basis with that of the liability valuation
• value reflects the position of the marginal investor rather than the individual (e.g. taxation)
• may not be the realisable value on sale (e.g. if dealing in large volumes or illiquid stocks)

Question 5

How are bonds valued

Answer 5

• Calculating the discounted value of the constituent cashflows - i.e coupon and redemption payment
• discount rate should reflect the riskiness of the payment and marketability of the bond

Question 6

How are equities valued

Answer 6

1. starting point is usually market value - if exists
2. discounted dividend model derives the value of the share
   - simplified discounted dividend model V=D/(i-g)
3. formula can be adjusted for changes in assumptions
4. other equity valuation methods include :
   - net asset value per share
   - value added methods, such as economic value added
   - measurable key factors of the companys business

Question 7

How is property valued

Answer 7

• Using an explicit discounted cashflow approach - this should be net of all outgoings
• discount rate should depend on the riskiness of the investment - could be based on the yield on a bond of suitable term plus margins for risk and lack of marketability

Question 8

How are derivatives valued

Answer 8

• options and futures are usually valued using techniques based on the principle of no arbitrage
• swaps can be valued by discounting the two components

Question 9

What are the methods for valuing equity

Answer 9

• market value
• dividend discount model
• net asset value per share
• value added measures (eg. shareholder value, economic value added)
• measurable key factors (when a company does not have shares)