Chapter 13: Valuation of investments Flashcards
On what does the appropriate valuation method depend
Reasons for the valuation - Valuation of asset make it possible to:
- Identify “value for money” investments
- Monitor experience of investment portfolio for
various purposes (unit pricing, actuarial valuations, bonus
declarations, accounting etc)
- Reporting requirements (regulation, listing
requirements, transparency and good practice)
Type of asset / asset characteristics
Valuation method characteristics
Aim and objectives of investment
Criteria for assessing asset valuation methods
- Readily available or not
- Subjective / objective
- Conservative / realistic
- Simple to obtain or complex to calculate
- How well it is understood
- Volatile asset value or not:
- Stability over time (and does it matter)
- Stability given investment switches
- Consistency with the liability valuation:
- Method (discontinuance vs ongoing)
- Basis / assumptions
Investment valuation methods
Book Value
- Historical
- Written up or written down
Market Value Related
- Market Value
- Smoothed Market Value
- Fair Value
- Arbitrage Value
Discounted Cashflow
- Deterministically Calculated
- Stochastic Modelling
What are the advantages and disadvantages of market value as a method of valuing assets?
Advantages:
1. Easily obtainable in most cases
2. Objective
3. Realizable value of an asset, so suitable for discontinuance valuations.
4. Well understood
5. May be required by legislation
Disadvantages:
- More than one market value is likely to exist
- Only known for certain at time of sale
- May not exist or be up t date for certain assets, such as direct property or unquoted investments
- Volatile
- Difficult to value liabilities in a consistent, market related way
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:
- Subjective choice of assumptions
- Time consuming
- Not well understood by clients
- Not suitable for short-term valuations
Outline how a stochastic model for valuing assets would work
- Uses the discounted cashflow method
- Future cashflows, or the interest rate, or both would be treated as random variables with a specified probability distribution
- Model is run many times
- 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.
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
Outline how bonds can be valued by methods other than market value
For a government bond, discount the coupon / redemption cashflows using market spot yields.
Ideally, term-specific yields should be used for calculation of different terms.
For a corporate bond, adjust the yield upwards for a security, marketability and liquidity premium.
Bonds with embedded options can be valued using option pricing techniques.
Suggest 5 ways of valuing equities
- Market value
- Discounted dividend model
- NAV per share
- Measurable key factor approach
- EVA
What is Economic value added (EVA)?
EVA is broadly determined as 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.
State the formula for the simplified dividend discount model, defining all terms used and stating 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 investor’s required rate or return
g is the dividend growth rate
Assumptions:
- Dividends paid annually with the next payment in 1 years time.
- Dividends grow at a constant rate g per annum
- The required rate of return, i, is independent of the time at which the payments are received and dividends can be reinvested at this rate.
- i and g are both real or both nominal with i > g
- Shares are held in perpetuity
- No taxes or expenses
Outline the measurable key factor approach to valuing equities
This method involves 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 business of the company.
How should a suitable discount rate be determined to value property?
Use a government bond yield of a suitable term and add a margin to reflect the risks associated with property.
For example:
- lack of marketability
- risk of voids
- default risk
- volatility of market value and illiquidity
- indivisibility
- depreciation and obsolescence
- costs (if not allowed for in cashflow)
List 2 methods of valuing swaps
- Discounted cashflow of income - outgo
- As the sum of a series of forward arrangements
