13. Valuation of investments Flashcards
Methods of valuing individual investments
SHAM FADS
- Smoothed market value
- Historic book value
- Adjusted book value
- Market value
- Fair value
- Arbitrage value
- Discounted cashflow
- Stochastic modelling
Advantages and disadvantages of market value as a method of valuing assets
CROWER MOVED
- Comparison to other valuation methods
- Realistic as realizable value on sale (assuming the bid price is used)
- Objective
- Well understood
- Easily obtainable in most cases
- Required by regulation sometimes
- May not reflect value of future proceeds
- May not be the realizable value on sale
- More than one market value is likely to exist
- Only known for certain at time of sale
- Volatile
- may not Exist or up-to-date
- Difficult to value liabilities in a consistent, market-related way
The market value method may be used as a filter for short-listing shares to buy or sell. State other key considerations
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- The nature, tern, cetainity and currency of the investor’s liabilities
- the investor’s tax position
- the investor’s risk appetite
- regulatory restrictions
- dealing costs
- temporary inefficiences in the market
What are the advantages and disadvantagesof using a discounted cashflow model to value investments
- +Method is consistent with a discounted cashflow approach to valuaing liabilities
- stable, if assumptions are not changed too frequently
- +Employs actuarial judgement => adjust out influence of market sentiment
- subjective choice of assumptions e.g. discount rate
- -Time-consuming
- -Not well understood by clients
- -not suitable for short-term valuations => discontinuance valuation
How Does a Stochastic Model for Valuing Assets Work?
- Uses the discounted cashflow method
- Future cashflow, interest rate, or both are treated as random variables with specific probability distributions
- Model is run many times
- Output is a distribution → Expected asset value and other statistics can be calculated
- Particularly appropriate where future cashflows depend on the exercise of embedded options (prob of exercising options)
What Are the Advantages and Disadvantages of the Stochastic Method?
Advantages:
* Good for valuing derivatives
* Provides a better picture of valuation by giving a distribution of results
* Achieves consistency with liability valuations
** Disadvantages:**
* Too complex for many applications
* Results depend on distribution assumptions → highly subjective
Equity valuation methods
M2END
Market value
Measurable key factor approach
Economic Value Added(EVA)
Net asset value per share
Discounted dividend model
What is arbitrage method of valuation
- proxy of the market value
- calculated by replicating the investment with other combinations of investments
- AND applying the condition that in an efficient market
- The values must be equal
- USED to value derivatives
What is the fair value of an asset
- The amount
- AN asset could be exchanged for
- OR liabilities settled for
- Between knowledgeable and willing parties
- in an arm’s length transaction
How can bonds be value other than market value
- Government bonds:
- Discount future coupon and redemption cashflows using market spot yields
- Ideally, term-specific yields are used for different cashflows
* Corporate bonds: - Adjust the yield upward for security, marketability, and liquidity premium
* Bonds with embedded options: - Use option pricing techniques (e.g., Black-Scholes)
What are the 4 ways of valuing equities
- Market value
- Discounted dividend model
- NAV per share → Used for investment trusts and property companies
- Measurable key factor approach
1. Economic value-added approach: - Operating profit less cost of capital over a year
- Measures value added by the company over a specific year
What Is the Measurable Key Factor Approach to Valuing Equities?
- Identify a relevant, measurable key factor for the company’s business
- Compare its relationship with the market price of other quoted companies
- Use as the basis for valuation
- Factor depends on the company’s business
What is the formula of discounted dividends cashflow method? Define all terms and assumptions (6)
V = D/(i-g)
- V is the value of the share
- D is the dividend in exactly one years time
- i is the investors required rate of return
- g is the dividend growth rate
Assumptions: - Dividends are paid annually with the next dividend in one years time
- Dividends grow at a constant rate g per annum
- i is independent of the time at which payments are received, and dividends can be reinvested at this rate
- i and g are either both real or both nominal i>g
- share is held in perpetuity
- No tax or expenses
How can a suitable discount rate be determined
- Use a government bond yield of a suitable term
- add margin to reflect risks associated with:
1. Lack of marketability
2. risk of voids if not allowed explicitly in the cashflows
3. default risk
4. volatility of market value and illiquidity
5. indivisibility
6. depreciation and obsolescence
7. additional costs if not allowed explicitly in the cashflows
What are the main consideration when valuing assets
- The purpose of the valuation
- Consistency with the liability valuation method
What are the two ways of valuing liabilities
- Use a discounted cashflow approach
1. with the same discount rate → long term expected return on assets
2. and consistent other assumptions (e.g. price inflation) =>model must be dynamic - V(A) at market value and liabilities using a discount cashflow model
1. discount rate used must be rate of return on an asset that closely replicates the liabilities - In BOTH cases → decide if discount rate should vary between:
1. Type of A/L
2. or term of each A/L cashflow
Are volatilities of V(A) a problem?
- Volatility reflects reality
- Inconsistency of valuation of V(A) with V(L) is a problem
- if V(L) calculated using a stable, long-term discounted cashflow and
- Unstable V(A) = hard to communicate
- Valuing L on a consistent, market related basis is hard to achieve
- As an alternative a smooth market could be used
How can property be valued
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Discounted cashflow approach
What are the two methods of valuing swaps
- Discounted cashflow of income - outgo
- Sum of series of forward arrangements
