12 - Valuation of Investments Flashcards
1
Q
What is the significance of market value in the valuation of investments?
A
- 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
2
Q
(1) What are the different methods to valuing investments?
(2) What are the characteristics of each of these methods to be considered?
A
(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
3
Q
Market valuation characteristics:
A
- 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)
4
Q
Why may someone selling an asset NOT obtain market value for it?
A
- 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
5
Q
Smoothed market value characteristics:
A
- 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
6
Q
Fair value defn for assets/liabilities:
A
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
7
Q
Discounted cashflow (DCF) method of valuation:
A
- 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)
8
Q
Stochastic models method of valuation:
A
- 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
9
Q
Arbitrage value method of valuation:
A
- 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
10
Q
Historical book value method of valuation:
A
- 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
11
Q
Written up/ written down book value
A
- 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
12
Q
How to value bonds:
A
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
13
Q
How to value bonds with option features:
A
- 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
14
Q
Methods for valuing equities:
A
- 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
15
Q
Market value method for valuing equities:
A
- Starting point for valuation of individual equity is the market value if there is a suitable market
16
Q
Dividend discount model for valuing equities:
A
- 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
17
Q
Assumptions of the dividend discount model:
A
- 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
18
Q
Issues to consider with the dividend discount model:
A
- 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
19
Q
Net asset per share method of valuation:
A
- 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
20
Q
How to value direct property:
A
- 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
21
Q
Factors to be considered when selecting discount rate for valuing property:
A
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
22
Q
Valuing a swap:
A
- 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)
23
Q
What are the different purposes for valuation?
A
- 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)
24
Q
Comments on using market value method to value a portfolio vs DCF:
A
- 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
25
Q
Comments on volatility of asset prices wrt valuation:
A
- 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
