Chapter 13: Valuation of investments Flashcards
(27 cards)
What is the role of the market value in valuing individual investments?
If the asset is traded on an open market and published prices are freely available, then market value is a reference point for all valuations.
If there is no market price, then other methods of determining the best proxy for market value should be used.
The actuary may decide to employ an alternative asset valuation method appropriate for the purpose of the valuation, in particular adopting consistent methods for the values of assets and liabilities. The trend has been to use a market value of assets (or a proxy to it) for all purposes and then to ensure equivalence by adopting a market-consistent method of valuing the liabilities.
List the 8 methods used to value individual investments
SHAM FADS
* Smoothed market value
* Historic book value
* Adjusted book value
* Market value
- Fair value
- Arbitrage value
- Discounted cashflow
- Stochastic modelling
What are the advantages and disadvantages of market value as a method of valuing assets?
Advantages:
1. Easily obtainable in most cases
2. Objective
3. Realisable value of an asset, so suitable for discontinuance valuations
4. Well understood
5. May be required by legislation
Disadvantages:
1. More than one market value is likely to exist
2. Only known for certain at time of sale
3. May not exist or be up to date for certain assets, such as direct property or unquoted investments
4. Volatile
5. Difficult to value liabilities in a consistent, market related way
Discuss smoothed market value
Where market values are available, they can be smoothed by taking some form of average over a specified period to remove daily fluctuations.
This method does not lend itself to consistent liability valuations because the appropriate discount rate for the liability valuation is indeterminate and requires judgement.
In practice, the assessment becomes a view as to whether the asset is cheap or expensive in relation to its smoothed market value.
Discuss fair value
In accounting terms, fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties at arm’s length.
This definition does not specify how such a value is calculated.
For most assets, in most market conditions, the fair value will simply be the market price.
Discuss the discounted cashflow method
This method involves discounting the expected future cashflows from an investment using long-term assumptions.
However, it relies on the assessment of a suitable discount rate, which is straightforward where the assets are, for example, high-quality fixed-interest stocks, but is less so otherwise.
What are the advantages and disadvantages of the discounted cashflow method of valuing assets?
Advantages:
1. Method is consistent with discounted cashflow approach to valuing liabilities.
2. Stable, if assumptions used are not changed too frequently
3. Employs actuarial judgement, so can adjust out influence of market sentiment
Disadvantages:
1. Subjective choice of assumptions
2. Time consuming
3. Not well understood by clients
4. Not suitable for short-term valuations
Discuss stochastic modelling
These are an extention of the discounted cashflow method in which the future cashflows, interest rates or both are treated as random variables.
The result of a stochastic valuation is a distribution of values from which the expected value and other statistics can be determined.
This method is particularly appropriate in complicated cases where future cashflows are dependent on the exercise of embedded options, such as the option to wind up in adverse financial circumstances.
What are the advantages and disadvantages of the stochastic modelling approach?
Advantages:
* It is good for valuing derivatives
* It gives a better picture of a valuation
* Consistency with the liability valuation is also achievable
Disadvantages:
* It may be too complex for many applications
* The results are dependent on the assumed distributions for the variables - these assumptions may be highly subjective
Discuss the arbitrage value method
Arbitrage value is a means of obtaining a proxy market value and is calculated by replicating the investment with a combination of other investments and applying the condition that in an efficient market the values must be equal.
The technique is often used in the valuation of derivatives.
In other markets, the technique is difficult or impossible to apply because it is difficult to replicate many assets.
Discuss (Historic) book value
This is the price originally paid for the asset and is often used for fixed assets in published accounts.
In its favour, this method is:
* objective
* conservative
* well understood
* used for some accounting purposes.
But for most valuation purposes, book value has little merit, since it is historical
Discuss written up or written down book value
Written up or written down book value is historic book value adjusted periodically for movements in value.
The current market value or the discounted cashflow value may influence the adjustment. But the adjusted book value may still not equal the market value
Arguably, this method is no more sensible than book value. Unlike book value, this method may be subjective.
Neither of these book value-based methods lends itself to the use of a consistent liability valuation.
Discuss how bonds can be valued
- Discounted cashflow approach: Government or similar high-quality bonds can be valued by discounting cashflows at rates consistent with the market spot rate yield curve. The market spot rate yield curve can be derived from the yields available on zero-coupon bonds, where they exist, or from governmetn bond “strips”. Other bonds, such as corporate bonds, can be valued similarly but adjusting the yield to allow for lower security and marketability
- Valuing bonds with option featuers: Bonds with option features should theoretically be valued using option pricing techniques, although this is not always done in practice.
What are callable and puttable bonds?
A callable bond is a bond that the borrower can choose to repay at any time.
Similarly, with a puttable bond, the investor can demand repayment at any time.
The value of a puttable bond to the investor - and so the market price - should equal:
* that of an otherwise identical bond that does not include an option
* plus the value of the choice provided by the option.
Suggest 5 ways of valuing equities
- Market value
- Discounted dividend model
- NAV per share
- Measurable key factor approach
- EVA
What is the general approach to the dividend discount model?
The general model can be expressed as the sum of all future dividends discounted to the present value.
What is the simplified model and what are its assumptions?
A simplified equation can be obtained by assuming that:
* dividends are payable annually, with the next payment in one year’s time
* dividends grow at a constant rate, g, per annum
* the required rate of return, i, is independent of the time at which payments are received.
* i > g
* i and g are defined consistently
* the dividend proceeds can be reinvested at i p.a.
* no tax and expenses
* Shares are held forever, as per the general model
The equation then simplifies to D/(i-g) where D is the dividend payable in one year from now.
Or V = D0(1+g)/(i-g)
Where D0 is the most recent dividend received
What are some of the issues to consider when applying the simplified model?
- We do not know the value of i to use in the model, and the assumption of a constant required rate of return i over time might not be appropriate.
- We do not know what the growth rate g should be, the constant dividend growth rate may also not be realistic.
- The results obtained are very sensitive to the assumed level of i-g
- The equations given above ignore tax. Tax-paying investors should use the net dividends received and a suitable after-tax rate of return.
- The equation also ignores expenses
- This model assumes annual dividend payments even though the payments might be half-yearly
- The model if of no use unless i>g
Discuss the net asset value per share method
A net asset value per share approach can be adopted for companies with significant tangible assets. A similar approach can be adopted to shares of a property investment company.
Such an approach would not give a realistic value for companies whose value comprises of significant intangible assets
Discuss the value added measures approach
Shareholder value is an attempt to get at the intrinsic or underlying value of an investment rather than its accounting value.
As an alternative, economic added value (EVA) looks at one year’s results and deducts the cost of servicing the capital that supports those results.
EVA acts as a bridge between quoted share value and accounting values to give a framework for executive compensation schemes designed to produce results that increase shareholder value.
Discuss other equity valuation methods
Where companies are not making profits and a net assset valuation is not appropriate, other methods have to be employed if a calculated valuation is required of an individual share.
The methods discussed above all implicitly assume at least one of the following:
* the company is declaring dividends
* it is making profits
* net asset valuation is suitable
These methods often involve determining a relevant and measurable key factor for the company’s business. The relationship between this factor and the market price of other quoted companies is then used as a basis for valuation. The factor used will depend on the business of the company.
Discuss property valuations
As with all investments, the true market value is only known when there is a transaction that equates a willing buyer with a willing seller. This doesn’t happen often with property.
Indications of the value can be taken from similar recent transactions but the uniqueness of each property means that considerable skill is needed to assess property market values. Such valuations must be regarded as a matter of the valuer’s opinion rather than fact.
Property can be valued using an explicit discounted cashflow approach, but as with equities it is now more common to use a market-consistent valuation of liabilities. The cashflows discounted should be net of all outgoings and should make explicit allowances for expected rental increases.
Allowance also needs to be made if the passing (i.e. current) rent is different from the current open market rental value.
The discount rate used should depend on the riskiness of the investment and could be based on the yield on a bond of suitable term, plus margins for factors such as risk and lack of marketability.
Outline the factors that should be considered in determining a suitable margin to use in the discount rate
- Use and size
- Location
- Prospects for rental growth
- Nature of lease
- Quality of tenant
- Quality of building
- Whether there are alternative uses for the property so that rental income can be maintained if the market for the present use fails
- Whether there is development potential
- Macro and microeconomic factors such as oversupply or a weak local economy.
Discuss the valuation of options, futures and swaps
Options and futures are usually valued using techniques based on the principle of ‘no arbitrage’. The value taken is the cost of closing out the contract by buying an equal and opposite option or future on current terms
Swaps can be valued by discounting the 2 component cashflows. At inception, the value of a swap to both parties will be zero, ignoring the market maker’s profit and expenses.
As market interest rates change, the value of the two cashflows will alter, leading to a positive net value for one party and a negative net value for the other.
The discount factors, and estimates of short-term rates for floating side of the swaps, are extracted from the appropriate yield curve. This is equivalent to viewing a swap as a combination of bonds.
An alternative way of viewing a swap contract is as a series of forward agreements. If each of these forward agreements can be valued, then so can the swap.
