Ch 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
1) Easily obtainable in most cases
2) Objective
3) Realizable value of an asset, so suitable for discontinuance valuations
4) Well understood
5) May be required by regulation
Disadvantages
1) More than one market value is likely to exist
2) Only known for certain at time of sale
3) May not exist or be up to date for certain assets, such as direct property or unquoted investments
4) Volatile
5) 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:
1) Method is consistent with discounted cashflow approach to valuing liabilities
2) Stable, if assumptions used are not changed too frequently
3) Employs actuarial judgement, so can adjust out influence of market sentiment
Disadvantages:
1) Subjective choice of investment
2) Time consuming
3) Not well understood by clients
4) Not suitable for short-term valuations
Property valuation
Discounted cashflow approach is mostly used.
Explicit allowance for:
- rent frequency
- rent increases
- expenses
- possibility of voids
- term of the lease
- redevelopment/refurbishment costs
Outline how a stochastic model for valuing assets would work
1) Uses the discounted cashflow method
2) Future cashflows, or the interest rate, or both would be treated as random variables with a specified probability distribution
3) Model is run many times
4) Output is a distribution of results from which the expected asset value and other statistics can be calculated
5) The output gives the set of possible outcomes with their respective probabilities
6) 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
Outline how bonds can be valued by methods other than market value
For a gov bond, discount the coupon and 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
1) Market value
2) Discounted dividend model
3) NAV per share
4) Measurable key factor approach
5) EVA
Fair value
The amount for which an asset could be exchanged or a liability settled/transferred between knowledgeable, willing parties in an arm’s length transaction.
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.
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 the ‘value added’ by the company over the specific year.
State the formula for the simplified dividend discount model, define 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 investors required rate of return
g is the dividend growth rate
Assumptions:
1) Dividends paid annually with the next payment in 1 years time
2) Dividends grow at a constant rate g per annum
3) The required rate of return, i, is independent of the time at which the payments are received and dividends can be reinvested at this rate
4) i and g are both real or both nominal with i>g
5) Shares are held in perpetuity
6) No taxes or expenses
State the 2 main considerations when determining the approach to take when valuing a portfolio of assets
1) The purpose of the valuation
2) Consistency with the liability valuation method
How should a suitable discount rate be determined to value property?
Use a government bond yield of a suitable term and add margins to reflect the risk associated with property
These risks include:
1) Lack of marketability
2) Risk of voids
3) Default risk
4) Volatility of market value and illiquidity
5) Indivisibility
6) Depreciation and obsolescence
7) Costs (if not allowed for in cashflows)
Suggest 2 ways of valuing assets and liabilities in a consistent manner
1) Valuing both assets and liabilities using a discounted cashflow approach, valuing both using the same interest for discounting the cashflows and consistent other assumptions.
2) 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 cashflow.
