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CP1 Flashcards > 12 - Valuation of Investments > Flashcards

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
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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

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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)
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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
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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
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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
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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)
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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
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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
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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
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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
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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
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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
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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
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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
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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

CP1 Flashcards (26 decks)

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