Chapter 12-Valuation of investments

Question 1

1. What is the reference point for all valuations of traded assets?

Answer 1

If the asset is traded on an open market and published prices are freely available then market value is a reference point for all valuations.

Question 2

2. What should be used if there is no market price?

Answer 2

If there is no market price then other methods of determining the best proxy for market value should be used.

Question 3

3. Describe the method used for the asset and liability valuation which aims to ensure consistency.

Answer 3

Increasingly the trend has been to use a market value of assets (or a proxy to it) for all purposes and then to ensure equivalence by adopting a market-consistent method of valuing the liabilities.

Question 4

4. Define historic and written-up or written-down book value and discuss their relevance to liability valuation.

Answer 4

Historic book value is the price originally paid for the asset and is often used for fixed assets in published accounts.
Written-up or written-down book value is historic book value adjusted periodically for movements in value.
Neither of these methods lends itself to the use of a consistent liability valuation (because the appropriate discount rate for the liability valuation cannot be determined).

Question 5

5. Discuss the usefulness of market values.

Answer 5

The market value of an asset varies constantly and can only be known with certainty at the date a transaction in the asset takes place. Even in an open market more than one figure may be quoted at any time. However, for many traded securities it is an objective and easily obtained figure and is a starting point for asset valuation.

Question 6

6. Discuss the use of smoothed market values.

Answer 6

Where market values are available they can be smoothed by taking some form of average over a specified period to remove daily fluctuations. This method does not lend itself to consistent liability valuations because the appropriate discount rate for the liability valuation is indeterminate and requires judgement. In practice the assessment becomes a view as to whether the asset is cheap or expensive in relation to its smoothed market value.

Question 7

7. Define fair value.

Answer 7

In accounting terms fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties at arm’s length. This definition does not specify how such a value is calculated.

Question 8

8. Discuss the use of the discounted cashflow method.

Answer 8

This method involves discounting the expected future cashflows from an investment using long-term assumptions. It has the advantage of being easily made consistent with the basis used to value an investor’s liabilities. However, it relies on the assessment of a suitable discount rate, which is straightforward where the assets are, for example, high quality fixed-interest stocks but is less so otherwise.

Question 9

9. Discuss the use of stochastic models in asset valuation.

Answer 9

These are an extension of the discounted cashflow method in which the future cashflows, interest rates or both are treated as random variables. The result of a stochastic valuation is a distribution of values from which the expected value and other statistics can be determined. This method is particularly appropriate in complicated cases where future cashflows are dependent on the exercise of embedded options, such as the option to wind up in adverse financial circumstances.

Question 10

10. Explain what is meant by arbitrage value and state when the technique is used.

Answer 10

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. The technique is often used in the valuation of derivatives.

Question 11

11. What does modern finance theory suggest about market values?

Answer 11

Modern finance theory suggests that where an efficient market exists, the resulting market value will reflect all publicly available information and is the underlying ‘economic value’ of the asset at a given point in time.

Question 12

12. What can it be argued is a problem with market values?

Answer 12

Market values can be subject to considerable fluctuation and it is sometimes argued that the use of market value depends on the vagaries of the market and obscures the underlying or intrinsic value of the asset.

Question 13

13. What is the counter-argument to the previous problem?

Answer 13

The counter-argument is that using another valuation method in an attempt to identify the intrinsic worth of an asset involves an investment call as to the direction the market in that asset (or class of asset) will move.

Question 14

14. Discuss the use of a market method or a calculated method for selecting shares for sale or purchase.

Answer 14

A market method or a calculated method can be used as a filter for selecting shares for sale or purchase for further consideration. In practice other factors would be taken into account before making buying or selling decisions.

Question 15

15. What is it important to do when using values other than market values?

Answer 15

If a value other than market value is used then it is important to make the implications of this clear to the client. This is particularly true when short-term solvency is being considered.

Question 16

16. Describe how bonds may be valued.

Answer 16

Government or similar high quality bonds can be valued by discounting cashflows at rates consistent with the market spot rate yield curve. Other bonds, such as corporate bonds, can be valued similarly but adjusting the yield to allow for lower security and marketability.
Many bonds have option features (eg callable and puttable bonds). Such bonds should theoretically be valued using option pricing techniques, although this is not always done in practice.

Question 17

17. What is the starting point for the valuation of an individual equity?

Answer 17

The starting point for valuation of an individual equity is the market value, if there is a suitable market.

Question 18

18. Describe in detail how to value a company using the discounted dividend model.

Answer 18

The discounted dividend model derives the value of a share as the discounted value of the estimated future dividend stream.
A simplified equation can be obtained by assuming that dividends are payable annually, with the next payment in one year’s time; that dividends grow at a constant rate, g, per annum; and that the required rate of return, i, is independent of the time at which payments are received.
V=D0*(1+g)/(i-g)
In order to calculate a value it is necessary to decide on an appropriate required rate of return. This would often be calculated as the yield on long-term government bonds plus an appropriate addition for the riskiness of the income stream. Investors with real liabilities might start from an index-linked government bond yield and estimate the real, rather than nominal, rate of dividend growth.
The equations given above ignore tax. Tax-paying investors should use the net dividends received and a suitable after-tax rate of return.
In practice it might be felt that constant dividend growth is not a realistic assumption. An alternative approach would be to use dividends based on profit forecasts for the first few years, then apply a short-term rate of growth for a period until the growth rate settled down to a long-term average.

Question 19

19. Outline how to determine the net asset value per share for an investment trust.

Answer 19

It is also possible to determine the market price (or proxy) for each shareholding in the investment trust.
These can be aggregated and divided by the number of shares in issue to give a net asset value per share. This is what the investors would receive, less expenses, if the investment trust was wound up, all its assets sold and the proceeds distributed to shareholders.
Investment trusts are frequently quoted as the market price being at a percentage premium or discount to NAV.

Question 20

20. Describe the concept of shareholder value with particular reference to Economic Value Added.

Answer 20

Shareholder value is an attempt to get at the intrinsic or underlying value of an investment rather than its accounting value. As an alternative, economic value added (EVA) looks at one year’s results and deducts the cost of servicing the capital that supports those results.
EVA acts as a bridge between quoted share value and accounting values to give a framework for executive compensation schemes designed to produce results that increase shareholder value.

Question 21

21. When will methods other than the discounted dividend model or NAV be appropriate for valuing shares?

Answer 21

Where companies are not making profits and a net asset valuation is not appropriate, other methods have to be employed if a calculated valuation is required of an individual share.

Question 22

22. Describe an alternative method.

Answer 22

These methods often involve 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 particular business of the company.

Question 23

23. How can discounted cashflow techniques be used to value a property?

Answer 23

Property can be valued using an explicit discounted cashflow approach, but as with equities it is now common to use a market-consistent valuation of liabilities. The cashflows discounted should be net of all outgoings and should make explicit allowances for expected rental increases. Allowance needs to be made if the passing (ie current) rent is different from the current open market rental value.

Question 24

24. Outline how to derive the discount rate used for the above.

Answer 24

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 factors such as risk and lack of marketability.

Question 25

25. How are futures and options normally valued?

Answer 25

Options and futures are usually valued using techniques based on the principle of ‘no arbitrage’. The value taken is the cost of closing out the contract by buying an equal and opposite option or future on current terms.

Question 26

26. How are swaps valued?

Answer 26

Swaps can be valued by discounting the two component cashflows.
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. Even if rates don’t differ from what was expected, the value of a swap is likely to be positive for parts of its term and negative for others.
An alternative way of viewing a swap contract is as a series of forward agreements. If each of these forward agreements can be valued, then so can the swap.

Question 27

27. Outline a simple way of valuing a portfolio of investments.

Answer 27

The straightforward way of valuing a portfolio of investments is to sum the market values of the individual holdings, or if there is no active market, a proxy market value.

Question 28

28. How does the method for valuing liabilities influence the choice of method for valuing assets?

Answer 28

The method and basis for any actuarial valuation will depend on the purpose of the valuation and the type of liability. For certain supervisory valuations the actuarial method and basis will be set out in regulations. In other cases there is less prescription.
It is important that the valuation of assets and liabilities are consistent. To achieve consistency this means that if assets are valued at market value then liabilities should be valued at appropriate market-based discount rates.
Alternatively, both assets and liabilities could be valued using the same interest rate, which would normally represent the long-term expected return on the assets held to back the liabilities.

Question 29

29. Describe how the discount rate used in valuing liabilities could be made consistent with a market valuation of assets.

Answer 29

Any market value implies an expected rate of return linked to the risk of the asset. Therefore, it can be argued that the use of a single discount rate to value all assets and liabilities is inappropriate and different discount rates should be used depending on the risks within the assets and liabilities to be valued and possibly other factors such as marketability and term.

Question 30

30. Is stability of asset valuation a desirable feature?

Answer 30

Volatility of asset value is often stated as the main problem with a market value of assets. However, it can be argued that stability itself is not a desirable feature of asset valuation, and that consistency overrides the question of stability. Volatility of asset value is not a problem in itself - a volatile asset value 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. In other words, the problem with a market value of assets is not the volatility of asset valuation as such, but inconsistency of asset and liability valuation bases.
In some situations, stability is considered a desirable feature of asset valuation. An unstable value of assets may make results harder to communicate and interpret. Also, it may be difficult in practice to establish a market-consistent value of liabilities.
One possible solution is to modify the method of valuing assets to make the value more stable and hence more consistent with a value of liabilities calculated using stable assumptions.
Some sort of smoothed market value is sometimes seen as the solution to the problem with market values.