8 Valuation methods

BOOK VALUE

- (historical) book value
- written up or written down book value

MARKET VALUE

- market value
- smoothed market value
- fair value
- arbitrage value

DISCOUNTED CASHFLOW

- discounted cashflow (deterministically calculated)
- stochastic modelling

Fair value

the amount for which an asset could be exchanged or a liability settled between KNOWLEDGEABLE, WILLING parties at ARM’S LENGTH.

What are the characteristics of market value as a valuation proxy?

Market values are generally

…. easily available,

…. objective and

…. well-understood.

However, they can be volatile in the short-term.

It can also be difficult to value liabilities in a consistent, market-based manner.

Bond valuation

Present value of coupon and redemption payments

Each cashflow is discounted at the market spot rate of the appropriate term, adjusted for:

- Risk of default
- Marketability
- Additional option features should theoretically be valued using option pricing techniques

Discounted dividend model

derives the value of a share as the discounted value of the estimated future dividend stream.

3 Equity valuation methods

• SHARE ANALYSIS

- — P/E Ratios
- — Other ratios - relevant and measurable

• VALUE ADDED MEASURES

- — EVA
- — PV[EVA]

• DISCOUNTED DIVIDEND MODEL

Property valuation

Discounted cashflow approach is mostly used

Explicit allowance for:

- rent frequency
- rental increases
- expenses
- possibility of voids
- term of the lease
- redevelopment / refurbishment costs

Options & futures valuation

Usually valued using techniques based upon the principle of no arbitrage, (option pricing methods)

Valuation of swaps

Valued by discounting the 2 component cashflows.

At inception, the value (at market rates of interest) 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 2 cashflows will alter, leading to a positive net value for one party and a negative net value to the other.

Historic book value

Price originally paid for the asset and is often used for fixed assets in published accounts.

Favourability of the (historic) book value method

It is:

- objective
- conservative
- well-understood
- used for some accounting purposes

Written up or written down book value

Historic book value adjusted periodically for movements in value.

Smoothed Market value

Where market values are available, they can be smoothed to remove daily fluctuations.

Fair value calculation

For most assets, the fair value will simply be the market price.

If the market price of an asset is not readily available, then a proxy might be sought in the form of an alternative fair value.

- seek an indicative price from a broker or market maker

- use a stochastic asset model to determine a market-consistent value

- use most recent known price and adjust in line with the movement of an appropriate index.

Discounted cashflow

Involves discounting the expected future cashflows from an investment.

Arbitrage value

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.

Callable bond

bond that the borrower can choose to repay at any time.

puttable bond

the investor can demand repayment at any time.

Value of a puttable bond to the investor

Equal to that of an otherwise identical bond that does not include an option, plus the time value of the choice provided by the option.

Valuing portfolios of shares

The valuation of a portfolio of ordinary shares would be carried out by assuming the shares were swapped for a holding in an index.

Appropriate valuation method depends on (3)

- Objective of the investment
- Reasons for valuation
- Type of asset

Valuation of assets make it possible to (2)

- Identify “value for money” investments

- Monitor experience of the investment portfolio

7 Criteria for assessing asset valuation methods

- Readily available or not
- Subjective / objective
- Conservative / realistic
- Simple to obtain or complex to calculate
- How well is it understood
- Volatile or not
- Consistency with liability valuation

Alternative way of viewing a swaps contract

As a series of forward contracts.

If each of these forward agreements can be valued, then so can the swap.

Stochastic models as a valuation method

- They are an extension of the discounted cashflow

method - 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.

Disadvantages of stochastic models for valuation

- they may be too complex for many applications
- the results are dependent on the assumed distributions

for the variables - these assumptions may be highly

subjective

Arbitrage

The simultaneous buying and selling of two economically equivalent, but differently priced portfolios so as to make an instant and risk-free profit.