Chapter 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
State the 2 main considerations when determining the approach to take when valuing a portfolio of assets
- The purpose of the valuation
- Consistency with the liability valuation method
What are the advantages and the disadvantages of market value as a method of valuing assets?
Advantages
EURO C
- Easy as it does not require calculations
- well Understood and accepted
- Realstic as realisable value on sale
- Objective
- can be used as a Comparison to other valuation methods to see whether an asset is under or over priced
Disadvantages
V DORM FC
- Volatile ; values may fluctuate in the short term
- Decision whether to use bid, mid or offer price
- may not be readily Obtainable
- may not be the Realisable value on sale
- value reflects position of the Marginal investor rather than the individual
- may not reflect the value of Future proceeds
- difficult to ensure Consistency of basis with that of liability valuations
What is smoothed market values
When market values are available, they can be smoothed by taking some form of average over a specified period to remove daily fluctuations
What is Fair value
Fair value is the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arm’s length transaction. (for most assets the fair value would just be the market price)
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 assumptions
2. Time-consuming
3. Not well understood by clients
4. Not suitable for short-term valuations
Stochastic model for valuing assets
- It is an extension of the discounted cashflow method in which future cashflows, interest rates or both are treated as random variables
- Output is a distribution of results from which the expected asset value and other statistics can be calculated
- 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.
What is (historic) book value
It is the price originally paid for the asset and is often used for fixed assets in published accounts
What is written up or written down book value
It is historic book value adjusted periodically for movements in value
Suggest 5 ways of valuing equities
- Market value
- Discounted dividend model
- NAV per share
- Value added measures
- Measurable key factor approach
State the formula for the simplified dividend discount model, defining all terms used and stating assumptions.
V = D/(i-g) or V = Do( 1+g)(1- tax rate)/(i-g)
V is the value of the share
D is the dividend in exactly one year’s time
i is the investor’s required rate or 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 divideds 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
What is value added measures?
values added measures such as economic value added (EVA) looks at operating profits over one year less the cost of capital supporting those results
It’s an attempt to get at the ‘value added’ by the company over the specific year
List 2 methods of valuing swaps
- Discounted cashflow of income - outgo
- As the sum of a series of forward arrangements
Suggest 2 ways of valuing assets and liabilities in a consistent manner
- Valuing both assets and liabilities using a discounted cashflow approach, valuing both using the same interest rate for discounting the cashflows and consistent other assumptions.
- 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 cashlflow.
