2-2. Financial Valuation Flashcards
Option pricing: What is option?
Contract that entitles owner to buy or sell an asset at a stated price within a specified period
Option pricing: what are 2 styles of option?
- American-style: option permits exercise anytime before expiration
- European-style: option permits exercise only at maturity date
Option pricing: how is option value determined?
- Current stock price relative to option price: greater the stock price over the (call) option price = greater the value of option
- Time to expiration of option: longer the time = greater the value of option
- Risk-free rate of return: higher the risk-free rate = greater the value of option
- Measure of risk of optioned asset: larger the standard deviation = greater the value of option
- Exercise price of option
- Dividend pmts on optioned security: smaller the dividends = greater the value of option
Option pricing: what is Black Scholes Model?
Developed to value options under specific circumstances
- For European call options
- Stock pays no dividends
- Stock prices increases in small increments
- Risk-free rate of return is assumed constant
Option pricing: what are 2 unique features incorporated in Black Scholes Model?
- Use of probability:
* probability that the price of the stock (security) will pay off by expiration date
* probability that the option will be exercised - Discounting of the exercise price
Option pricing: what is Binomial Model (BOMP)?
For determine the value of an option.
Uses tree diagram to estimate values at a number of time points between the valuation date and the expiration date.
Option pricing: What is the steps of Binomial Model?
- Generate price tree diagram: use a branch for each desired time period until expiration
- Calculate option value at each tree end node as of the expiration date
- Calculate option value at each preceding node back to present valuation date
Option pricing: Binomial Model example: Assume 1 year stock option; exercise price=$100. Probability of expected value high of $120 is 60%, probability of expected value low of $80 is 40%. Discount rate = 10%.
Step 1 and 2:
One estimates that expected option price at expiration date could be as high as $20 ($120-100) or as low as $0 (80-100).
Step 3:
Expected value = [(60% x $20) + (40% x $0)] / 1.10 = $10.91
Option pricing: Binomial Model: what to do when there are multiple time periods?
The expected outcome of one period would be the input for prior period - you work backwards.
Continue to work backwards until you get the current value.
What is business valuation?
The estimation of the economic value of a business entity or portion thereof.
Business valuation: What are 4 steps?
- Establishing standards and premise of valuation
- Assessing economic environment of entity being valued
- Analyzing financial statements and related info
- Formulating value
Business valuation: Describe the first step.
Establishing stds/premise:
Identify reasons for and circumstances of valuation
- Stds: establish conditions of valuation
*Is valuation;
legally or otherwise mandated?
at request of and for owners?
for prospective buyer?
- Premise: establish assumptions to be used
*Will;
business continue as single going concern?
business be separated into separate units?
assets be sold separately?
Business valuation: Describe the second step.
Assessment of environment:
- General economic environment
- Specific operating economic environment
- Economic nature of industry
- Economic conditions of physical location
Business valuation: Describe the third step.
FS analysis:
- Common-size analysis - converting dollar amounts to percentage for comparison over time and with other entities
- Trend analysis - determining changes in important measures over time
- Ratio analysis - determining important ratios to assess change and compare with other entities
- Making adjustments to stmts to better reflect normal, on-going operations
Business valuation: what are 3 alternative approaches?
Market approach, income approach, asset approach.
Business valuation: what is market approach? what is it also called?
Determines value of a business by the comparing it with highly similar entities for which there is a readily determinable value.
Called Guideline Public Company method.
Business valuation: what are adjustments that may be needed for market approach?
- Premium for controlling interest in business being valued
- Discount for lack of controlling interest in business being valued
- Discount when business being valued is not as marketable as entity on which its value is based
Business valuation: market approach: Disadvantages?
- Difficulty in identifying highly comparable entities for which there is a ready and objective market value
- Difficulty in determining appropriate liquidity (“salability”) and other discounts in valuing the comparable entity
Business valuation: what is income approach?
Determines value by calculating net PV of the benefits stream generated by the entity being valued.
Business valuation: income approach: what is entity value? How is it determined?
Entity value = Net PV.
Net PV is computed using discount rate.
Discount rate is based on rate of return needed to attract investors funding given the level of risk.
Business valuation: what are alternatives income approach?
- Discounted cash flows: uses discounted cash flow to get PV (WACC, CAPM)
- Capitalization of earnings: applies capitalization or interest rate to earnings to get value
- Earnings multiple: applies a multiple factor to earnings to get value
- Free cash flow: applies discount rate to free cash flows to get PV (a variation of discounted CF)
Business valuation: what is asset approach?
Determines value by adding values of individual assets that comprise the entity being valued.
Business valuation: what are the steps of asset approach?
- FV of each individual asset/liability is determined
2. Sum of net asset is valued of entity
Business valuation: asset approach: how is the valuation of asset done?
Using specific valuation technique;
income approach, market approach, cost approach
Business valuation: asset approach: what are the assets difficult to value alone?
Intangible assets (e.g. trademark)
Business valuation: asset approach: when is it less/more appropriate?
Less:
- For valuing going concern
- For valuing non-controlling interest
More:
- For valuing entity in liquidation
- For entity with little or no CF or earnings
