13 - Valuation of investments Flashcards
List 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:
- Easily obtainable in most cases
- Objective
- Realizable value of an asset, so suitable for discontinuance valuations.
- Well understood
- May be required by legislation
Disadvantages:
- More than one market value is likely to exist
- Only known for certain at time of sale
- May not exist or be up t date for certain assets, such as direct property or unquoted investments
- Volatile
- Difficult to value liabilities in a consistent, market related way
What are the advantages and disadvantages of the discounted cashflow method of valuing assets?
Advantages:
- Method is consistent with discounted cashflow approach to valuing liabilities
- Stable, if assumptions used are not changed too frequently
- Employs actuarial judgement, so can adjust out influence of market sentiment.
Disadvantages:
- Subjective choice of assumptions
- Time consuming
- Not well understood by clients
- Not suitable for short-term valuations
Outline how a stochastic model for valuing assets would work
- Uses the discounted cashflow method
- Future cashflows, or the interest rate, or both would be treated as random variables with a specified probability distribution
- Model is run many times
- Output is a distribution of results from which the expected asset value and other statistics can be calculated.
- Is particularly appropriate in complicated cases where future cashflows are dependent on the exercise of embedded options
Outline the arbitrage value valuation 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.
Fair value
Fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction.
Outline bonds can be valued by methods other than market value
For a government bond, discount the coupon / redemption cashflows using market spot yields.
Ideally, term-specific yields should be used for calculation of different terms.
For a corporate bond, adjust the yield upwards for a security, marketability and liquidity premium.
Bonds with embedded options can be valued using option pricing techniques.
Suggest 5 ways of valuing equities
- Market value
- Discounted dividend model
- NAV per share
- Measurable ket factor approach
- EVA
What is EVA?
EVA is broadly determined as operating profits over one year less the cost of capital supporting those results.
It’s an attempt to get at the ‘value added’ by the company over the specific year.
State the formula for the simplified dividend discount model, defining all terms used and stating assumptions.
V = D/(i-g)
V is the value of the share
D is the dividend in exactly one year’s time
i is the investor’s required rate or return
g is the dividend growth rate
Assumptions:
- Dividends paid annually with the next payment in 1 years time.
- Dividends grow at a constant rate g per annum
- The required rate of return, i, is independent of the time at which the payments are received and divideds can be reinvested at this rate.
- i and g are both real or both nominal with i > g
- Shares are held in perpetuity
- No taxes or expenses
Outline the measurable key factor approach to valuing equities
This method involves 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.
How should a suitable discount rate be determined to value property?
Use a government bond yield of a suitable term and add a margin to reflect the risks associated with property.
For example:
- lack of marketability
- risk of voids
- default risk
- volatility of market value and illiquidity
- indivisibility
- depreciation and obsolescence
- costs (if not allowed for in cashflow)
List 2 methods of valuing swaps
- Discounted cashflow of income - outgo
2. As the sum of a series of forward arrangements
State the 2 main considerations when determining the approach to take when valuing a portfolio of assets
- The purpose of the valuation
2. Consistency with the liability valuation method
Suggest 2 ways of valuing assets and liabilities in a consistent manner
- Valuing both assets and liabilities using a discounted cashflow approach, valuing both using the same interest rate for discounting the cashflows and consistent other assumptions.
- Value assets using market value. Obtaining a market value of liabilities is difficult since they are not frequently traded.
Therefore, determine a market - related discount rate for the liabilities and value using a discounted cashflow approach.
In both cases a decision has to be made as to whether the discount rate should vary by type of asset/liability or by term of each asset / liability cashlflow.
Discuss whether volatility of asset values is a problem
- Volatility reflects reality
- Inconsistencies of asset values with liability values is a problem, if the latter are calculated using a stable, long term discounted cashflow method.
- However, an unstable asset value is hard to communicate.
- Valuing liabilities on a consistent, ‘market related’ basis is hard to achieve.
- As an alternative, a smoothed marked value could be used.
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)
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.
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.
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
