Ch 13: Valuation of investments

Question 1

List 8 methods used to value individual investments

Answer 1

SHAM FADS

Smoothed market value
Historic book value
Adjusted book value
Market value

Fair value
Arbitrage value
Discounted cashflow
Stochastic modelling

Question 2

What are the advantages and disadvantages of market value as a method of valuing assets?

Answer 2

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

Question 3

What are the advantages and disadvantages of the discounted cashflow method of valuing assets?

Answer 3

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

Question 4

Property valuation

Answer 4

Discounted cashflow approach is mostly used.

Explicit allowance for:
- rent frequency
- rent increases
- expenses
- possibility of voids
- term of the lease
- redevelopment/refurbishment costs

Question 5

Outline how a stochastic model for valuing assets would work

Answer 5

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

Question 6

Outline how bonds can be valued by methods other than market value

Answer 6

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.

Question 7

Suggest 5 ways of valuing equities

Answer 7

1) Market value
2) Discounted dividend model
3) NAV per share
4) Measurable key factor approach
5) EVA

Question 8

Fair value

Answer 8

The amount for which an asset could be exchanged or a liability settled/transferred between knowledgeable, willing parties in an arm’s length transaction.

Question 9

State the 2 main considerations when determining the approach to take when valuing a portfolio of assets

Answer 9

1) The purpose of the valuation
2) Consistency with the liability valuation method

Question 10

Suggest 2 ways of valuing assets and liabilities in a consistent manner

Answer 10

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.

Question 11

Favorability of the historic book value method

Answer 11

It is:
- objective
- conservative
- well-understood
- used for some accounting purposes

Question 12

Options and futures valuation

Answer 12

Usually valued using techniques based upon the principle of no arbitrage (option pricing methods)

Question 13

Callable bond

Answer 13

Bond that the borrower can choose to repay at any time

Question 14

Written up or written down book value

Answer 14

Historic book value adjusted periodically for movements in value

Question 15

Value of a puttable bond to the investor

Answer 15

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.

Question 16

7 criteria for assessing asset valuation methods

Answer 16

• 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

Question 17

Puttable bond

Answer 17

The investor can demand repayment at any time

Question 18

Fair value calculation

Answer 18

For most assets, the fair value will simply be the market price.
If the market 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

Question 19

Historic book value

Answer 19

Price originally paid for the asset, and is often used for fixed assets in published accounts.

Question 20

Smoothed market value

Answer 20

Where market values are available, they can be smoothed to remove daily fluctuations

Question 21

Discuss whether volatility of asset values is a problem

Answer 21

1) Volatility reflects reality
2) Inconsistencies of asset values with liability values is a problem if the liabilities are calculated using a stable, long-term discounted cashflow model.
3) However, an unstable asset value is hard to communicate.
4) Valuing liabilities on a consistent, ‘market-related’ basis is hard to achieve
5) As an alternative, a smoothed market value could be used

Question 22

List 2 methods of valuing swaps

Answer 22

1) Discounted cashflow of income-outgo
2) As the sum of a series of forward agreements

Question 23

How should a suitable discount rate be determined to value property?

Answer 23

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)

Question 24

State the formula for the simplified dividend discount model, define all terms used and stating assumptions.

Answer 24

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

Question 25

What is EVA?

Answer 25

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.

Question 26

Outline the measurable key factor approach to valuing equities

Answer 26

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.

Question 27

Outline the arbitrage value valuation method

Answer 27

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