CH12 - Valuation of investments

Question 1

Valuation methods for individual investments (8)

SHAM FADS

Answer 1

There are many different ways in which assets can be valued, with a trend towards the use of market value. 
Common methods of valuing assets include:
1. (historic) book value
2. written up or written down book value
3. market value
4. smoothed market value
5. fair value
6. discounted cashflow
7. stochastic modelling
8. arbitrage value

The fair value of the asset is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties at arm’s length.

Question 2

Market values vs calculated values - advantages (5)

Answer 2

1. objective
2. realistic as realisable value on sale (assuming the bid price is used)
3. easy as doesn’t require calculation
4. well understood and accepted
5. can be used as a comparison to other valuation methods to see whether an asset seems over or underpriced.

Question 3

Market values vs calculated values - disadvantages (7)

Answer 3

1. may not be readily obtainable (e.g. unquoted instruments)
2. volatile - values may fluctuate greatly even in the short term
3. may not reflect value of future proceeds
4. a decision is required about whether bid, mid or offer prices should be used
5. difficult to ensure consistency of basis with that of the liability valuation
6. value reflects the position of the marginal investor rather than the individual (e.g. taxation)
7. may not be the realisable value on sale (e.g. if dealing in large volumes of iliquid stocks)

Using a value other than market value implies taking view as to where the market is going. Under such circumstances the actuary must ensure the client understands the implications, especially with respect to short-term solvency.

Question 4

Bond valuations

Answer 4

Bonds can be valued by calculating the discounted value of the constituent cashflows, i.e the coupon and redemption payment.
The discount rate should be adjusted to reflect the riskiness of the payment and the marketability of the particular bond.

Question 5

Equity valuations

Answer 5

The starting point is usually the market value, if one exists.
The discounted dividend model derives the value of a share as the discounted value of the estimated future dividend stream.

Question 6

Equity general discounted dividend model

Answer 6

The general discounted dividend model, for the value V of a share, is given by:
V = SUM (from t = 1 to infinity) of Dt v(t)
where
Dt is the gross amount of the tth dividend payment
v(t) is the discount factor applied between time 0 and the time of the tth dividend payment

Question 7

Equity simplified discounted dividend model

Answer 7

The simplified discounted dividend model, for the value V of a share, is given by:
V = D / (i - g)

The definitions and assumptions underlying this discounted dividend model are:

1. D is the prospective dividend, paid annually, starting in one year
2. g is the assumed constant rate of growth each year in dividend payments ad infinitum
3. i is the required constant annual rate of return from the share(s)
4. i > g
5. i and g are defined consistently, e.g. both include or both are net of inflation
6. dividend proceeds can be reinvested at i pa
7. tax and expenses are ignored

The valuation formula can be modified for any changes in the assumptions

Question 8

Other equity valuation methods (3)

Answer 8

1. Net asset value per share
2. Value added methods, such as economic value added (EVA)
3. Measurable key factors of a company’s business.

Question 9

Property valuations

Answer 9

Property can be valued using an explicit discounted cashflow approach. The cashflows valued should be net of all outgoings and should make explicit allowances for the expected rate of increase of rental income.
The discount rate used should depend on the riskiness of the investment and could be based on the yield on a bond of suitable term, plus margins for risk and lack of marketability.

Question 10

Valuation of derivatives

Answer 10

• Options and futures are usually valued using techniques based upon the principle of no arbitrage.
• Swaps can be valued by discounting the two component cashflows. For an interest rate swap, at inception the value (at market rates of interest) of a swap to both parties will be zero, ignoring the market maker’s profit and expenses.
  As market interest rates change the value of the two cashflows will alter, leading to a positive net value for one party and a negative net value to the other.

Question 11

Placing a value on portfolio of investments

Answer 11

The most widely used method of actuarial purposes is market value.
The method and basis for any actuarial valuation will depend on the purpose of the valuation and the type of liability. In some cases, the method and basis will be prescribed by regulations.
It is important that the valuation of assets and liabilities are done consistently.
If a market value approach is used to value the assets, then the liabilities must be valued using a market-based discount rate, which can be difficult to determine.
Discounted cashflow methods for valuing assets can be more easily be made both stable and consistent with the valuation of the liabilities (which is typically done using a discounted cashflow approach.

Question 12

Allowing for the variability of asset prices

Answer 12

Volatility of asset prices is not a problem in itself as it may correctly reflect the underlying reality.
However, in the context of the ongoing valuation of a long-term fund, comparing volatile asset values with a value of liabilities calculated using a stable interest rate is potentially misleading.