Chapter 13: Valuation of investments Flashcards
Why do different investors use different methods to value assets?
- Their general aims and objectives of invesments
- The reasons for valuing a particular asset
- The type of asset being values
Advantage of using market consistent methods to value liabilities
The value of assets and liabilities will react in similar ways to changes in the investment environment
Valuation methods for individual investments
- Market value - known the date the transaction takes place, can be very volatile and difficult to find for unquoted assets
- Smoothed market value
- fair value
- discounted cashflow
- stochastic models
- arbitage value
- historic book value - Price originally paid for asset
- written up or written down book value - historic book value, adjusted periodically for movements in value
Advantages of using market values for valuation
- Objective
- Easy as it does not require calculation
- Realistic as realisable sale value (assuming bid price is used)
- Well understood and accepted
- Can be used in comparison to other valuations to see whether an asset is under or over priced
Disadvantages of using market values for valuation
- May not be readily attainable
- Volatile - values may fluctuate greatly, even in the short term
- May not reflect value of future proceeds
- A decision is required as to whether bid, ask or mid prices should be used
- Difficult to ensure consistensy of basis with that of liability valuation
- May not be realisable value on sale
Smoothed market value
Takes an average of market values over a specific period to remove daily fluctuations
* Does not lead to consistent liability valuations since the choice of discount rate of liabilities requirees judgement
Fair value
The amount which an asset can be exchanged or liability settled between two knowledgable, willing parties at arms length
* It is the market price if market price is available
* Otherwise a proxy to market value is used
Discounted cashflow model
Values assets by discounting future income and capital
* Advantage is that it is consistent with the valuation of liabilities
* Disadvantage is that it highly relies on specifying a discount rate, which may be subject to judgement
Advantages of stochastic models
- Can be used to value derivatives
- Gives a better picture of the valuation by giving a distribution of results
- Consistency with liabilities is achievable
Disadvantages of stochastic models
- May be too complex
- The results are dependent on the assumed distributions
Arbitage value
Obtaining a proxy for market value using a replicating portfolio and the law of one price
* Technique may be difficult or impossible to use in markets where it is difficult to replicate assets
Historic book value
Uses the price at which the asset was bought
Advantages:
* Objective
* Conservative
* Well understood
* Used for some accounting purposes
Disadvantage: Little merit since it is historic
Bond valuations methods
- Use discount model
- Where the discount rate is adjusted for marketibility and riskiness
Callable bond
- The borrower(issuer) can choose to pay back the bond at any time.
- Thus the price is lower than a bond without the option to make up for the uncertainty of the timing of cashflows that the investor might experience
Puttable bond
- The investor can demand repayment at any time.
- Price is higher to pay for the choice that the investor has to get the money anytime
