Valuing individual investments Flashcards
(10 cards)
Why is valuing individual investments crucial?
o Seeing when assets are undervalued or overpriced and hence decide on whether to
buy them
o Monitoring the ongoing performance of individual assets
Valuation by market value (advantages and disadvantages)
- Market value
o Varies constantly and can only be known with certainty at date of transaction in
the assets take place
o Even in an open market, more than one figure may be quoted at the same time
o Quoted shares generally have the following prices
▪ Bid price - price at which market makers are prepared to buy
- Should instead be used for some purposes – assessing realisable
value of portfolio with allowance for sale costs and tax
▪ Offer price - price at which market makers are willing to sell at (higher)
▪ Mid-market value - average of bid and offer price
o Advantages of market values are :
▪ Generally fairly easily available
▪ Objective
▪ Well understood and accepted
▪ Realistic as it is the realisable value on sale
▪ Can be used to check under-pricing and over-pricing of of assets
o Problems that arise when using market values
▪ Volatility - Market values may be subject to volatility in the short term
- May give quite different results from a valuation depending on
exact date
▪ Achieving consistency - The volatility of market values makes it difficult to value liabilities
consistently unless they are closely matched
▪ Not quoted price - Determining market value for quoted securities is relatively
straightforward - This is not true for unquoted investments – direct property and
venture capital holdings
▪ May not be readily available or obtainable
▪ May not reflect future proceeds
▪ Decision about whether to use the bid, of fer or mid prices should be
used
▪ Difficulty to ensure consistency of basis with that of liability valuation
▪ May not be realisable value on sale – if dealing with large volumes or illiquid
values
Valuation by smoothed market value:
o Case where the market values are smoothed by taking sone form of average over a
specified period to remove daily fluctuations – such as using moving averages
o Does not lend itself to consistent liability valuations – because liability discount rate
is indeterminate ad requires judgement
o There may be judgement on
▪ Length of smoothing process
▪ Whether average is simple or weighted with more weight on recent values
o This assessment becomes a view as to whether the asset is cheap or expensive in
relation to its smoothed market value
Valuation by fair value
o There has been a move towards market-based methods of valuations
o It is part of the methods of financial reporting by accountants
o Fair value is the amount of which an asset could be exchanged or a liability settled
between knowledgeable , willing parties at arm’s length
o The definition does not specify how this value is calculated
▪ for most assets , the fair value will be the market value
▪ If the market price if an asset is not readily available, then the proxy might
be sought in the form of an alternative fair value
▪ Various options for calculating fair value of assets :
* Seek indicative price from broker or market maker
* Use the most recent known price and adjust in line with movement
in an appropriate index
* Use stochastic asset model
Valuation by discounted cashflow
It involves discounting the expected future cashflows from investments using long
term assumptions
o Values assets as present value of expected income and capital from assets
o Advantage : consistent with the basis use to value an investor’s liabilities and use
same approach to determine the discount rate
o Portfolio of assets – weighted discount rate can be calculated
o Relies on the discount rate which may not be straightforward for other assets
Valuation by stochastic models
o Extension of discounted cashflow model
o The future cashflow , interest rates or both are treated as random variables
o Results in distribution of values from which expected value and other statistics can
be determined
o Appropriate for cases where future cashflow are dependent on the exercise of an
option
o Advantages of stochastic models :
▪ Good for valuing derivatives
▪ Gives better picture of valuation – by giving a distribution if results
▪ Consistency with the liability valuation is also achievable
o Disadvantages of stochastic model :
▪ May be too complex for many applications
▪ Results are dependent on assumed distribution for variables – assumptions
are highly subjective
Valuation by arbitrage value
Means of obtaining a proxy market value
o 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
o Often used to value derivatives ( futures and options )
▪ The technique may be too difficult or impossible to apply because it is
difficult to replicate many assets
Valuation by book (historic) value
o The price originally paid for the asset and is often used for fixed assets in published
accounts
o Advantages
▪ Objective
▪ Conservative – only if the purchase value has risen
▪ Well understood
▪ Used for accounting purposes
o Has little merit since it’s a historic value
Valuation by written up and written down book value
o Historic book value adjusted periodically for movements in value
o For example, property investment may be revalued , say every 3 years
o The current market value or discounted cashflow value may influence the
adjustments
▪ Adjusted book value may still not equal market value
o More sensible than book value
▪ Unlike the book value, this method is subjective
o Do not use consistent -liability valuation
Market value compared with calculated values
- Market values are subject to considerable fluctuations
- It is argued that the use of market values obscures the underlying or intrinsic value of the
asset - It is also argued that using another valuation method in attempt to identify the intrinsic
worth of an asset involves an investment call as to the direction the market in that class will
move - A market method or calculation method can be used as a filter for selecting shares for sale
and purchase for further considerations - However other factors would need to be taken into consideration before making buying and
selling decisions ( purchasing and sale is under changing investment strategy) - These factors include :
o Characteristics of investor’s liabilities
o Investor’s tax position
o Investor’s risk appetite
o Regulatory restrictions
o Dealing costs
o Temporary inefficiencies in the market
o Method used in valuing – and the reason for using method other than the market
value
▪ This is important for the purpose of valuation – could be short term solvency
calculations
