Chapter 13: Valuation of investments Flashcards
What are 8 methods used to value individual investments?
SHAM FADS
1> Smoothed market value
2> Historic book value
3> Adjusted book value
4> Market value
5> Fair value
6> Arbitrage value
7> Discounted cashflow
8> Stochastic modelling
What are the advantages and disadvantages of market value as a method of valuing assets?
Advantages
1> Objective
2> Suitable for discontinuance valuation => Realistic as realisable value on sale (assuming bid price is used)
3> easy obtainable as it does not require calculation
4> Well understood and accepted
5> May be required by regulation
6> Can be used as a comparison to other valuation methods
Disadvantages
1> More than one value is likely to exist
2> May not be readily obtainable
3> Volatile - values may fluctuate greatly in the short term
4> Decision required about whether bid, mid or offer price should be used
5> Difficult to ensure consistency of basis with that of the liablility valuation
6> value reflects the position of marginal investor rather than the individual (e.g. taxation)
7> may not be realisable value on sale (e.g. if dealing in large or illiquid stocks)
What are the advantages and disadvantages of using a discounted cashflow model of to value investments?
Advantages
+> Method consistent with a discounted cashflow approach of valuing liabilties
+> stable, if assumptions are not changed too frequently
+> Employs actuarial judgement=> adjust out influence of market sentiment
Disadvantages
-> Subjective choice of assumptions, discount rate
->Time-consuming
-> Not well understood by clients
-> Not suitable for short-term valuations=> discontinuance valuation
How does a stochastic model for valuing assets work?
1> Uses the discounted cashflow method
2> Future cashflow, the interest rate, or both are treated as random variables=> with a specific probability distribution
3> Model is run many times
4> Output is a distribution=> Expected asset value and other statistics can be calculated.
5> Particularly appropriate where future cashflows are dependent on the exercise of embedded options
What is the arbitrage valuation method?
1> Proxy of the market value
2> Calculated by replicating the investment with other combinations of investments
3> AND applying the condition that in an efficient market (principle of no arbitrage)
4> The values must be equal
5> USED to value derivatives
What is the fair value of an asset?
- The amount
- AN asset could be exchanged for
- OR liabilities settled for
- Between knowledgeable
- Willing parties in an arm’s length transaction
How can bonds be valued by methods other than market value?
1> Government bonds=> discount future coupon and redemption cashflows using market spot yields
2> Ideally term specific yields will be used for cashflows of different times
3> Corporate bonds=> adjust the yield upward for security+ marketability+ liquid premium
4> Bonds with embedded options=> option pricing techniques
8) What are 5 ways of valuing equities?
1> Market value
2> Discounted dividend model
3> NAV per share=> Investment trust+ property companies
4> Measurable key factor approach
5> Economic value-added approach=> OP-Cost of capital
i. Attempts to get the value added by the company over a specific year
What is the formula for the simplified discounted dividend model, defining all terms used and assumptions?
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:
i. Dividends are paid annually with the next dividend in one years time
ii. Dividends grow at a constant rate g per annum
iii. i is independent of the time at which payments are received, and dividends can be reinvested at this rate
iv. i and g are either both real or both nominal i>g
v. share is held in perpetuity
vi. No tax or expenses
What is the measurable key factor approach of valuing equities?
1> Determining a relevant and measurable key factor for the company’s business
2> Relationship between this factor and the market price of other quoted companies
3> USED as the basis for valuation
4> Factor used depends on the business of the company
How can property be valued?
Discount cashflow approach
How can a suitable discount rate be determined?
Use a government bond yield of a suitable term+ add margin to reflect risks associated:
i. Lack of marketability
ii. Risk voids
iii. Default risk
iv. Volatility of market value and illiquidity
v. Indivisibility
vi. Depreciation and obsolescence
vii. Costs=> if not allowed for in the cashflows
What are 2 methods of valuing swaps?
1> Discounted cash flow of income—outgo
Vswap = Bfixed - Bfloating
2> As a sum of a series of forward arrangements
What are the two main considerations when determining the approach to take when valuing a portfolio of assets?
1> The purpose of the valuation
2> Consistency with the liability valuation method
What are two ways of valuing Assets and liabilities in a consistent manne
1> Use a discounted cashflow approach
i. With the same discount rate=> long term expected return on assets
ii. Consistent other assumptions=> model must be dynamic
2> V(A) market value+ liabilities using a discount cashflow model
i. Discount rate used should be rate of return on a portfolio of assets that closely replicate the liabilities
3> IN both case=> discount rate should vary between:
i. Type of A/L
ii. OR term of each A/L cashflow
