Chapter 13: Valuation of investments Flashcards
List the 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
Discuss market value as a method of valuing assets
The market value of an asset varies constantly 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.
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. Realisable value of an asset, so suitable for discontinuance valuations
4. Well understood
5. May be required by legislation
Disadvantages:
1. More than one market value is likely to exist
2. Only known for certain at time of sale
3. May not exist or be up to date for certain assets, such as direct property or unquoted investments
4. Volatile
5. Difficult to value liabilities in a consistent, market related way.
Discuss smoothed market value as a method of valuing assets
Where market value 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 becuase the appropriate discount rate for the liability valuation is indeterminate and requires judgement.
Discuss fair value as a method of valuing assets
In accounting terms, fair value is the amount for which an asset coiuld 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.
For most assets, in most market conditions, the fair value will simply be the market price.
Discuss discounted cashflow as a method of valuing assets
This method involves discounting the expected future cashflows from an investment using long-term assumptions.
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.
Discuss stochastic models as a method of valuing assets
This is 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.
What are the advantages and disadvantages of stochastic models as a method of valuing assets?
Advantages:
* it is good for valuing derivatives
* it gives a better picture of a valuation, e.g. by giving a distribution of results
* consistency with the liability valuation is also achievable
Disadvantages:
* it may be too complex for many applications
* the results are dependent on the assumed distributions for the variables - these assumptions may be highly subjective
Discuss arbitrage value as a method of valuing assets
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.
Discuss (Historic) book value as a method of valuing assets
This is the price originally paid for the asset and is often used for fixed assets in published accounts.
In its favour, this method is:
* objective
* conservative
* well understood
* used for some accounting purposes
But for most valuation purposes, book value has little merit, since it is historical
Discuss written up or written down book value as a method of valuing assets
Written up or written down book value is historic book value adjusted periodically for movements in value.
The current market value or the discounted cashflow value may influence the adjustment, but the adjusted book value may still not be equal to the market value.
Arguably, this method is no more sensible than book value. Unlike book value, the method may be subjective.
Neither of these book value-based methods lends itself to the use of a consistent liability valuation.
Discuss the methods for valuing bonds
Discounted cashflow approach:
* 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 secutiry and marketability.
Valuing bonds with option features:
* Many bonds have option features
* A callable bond is a bond that the borrower can choose to repay at any time. Similarly, with a puttable bond, the investor can demand repayment at any time
* Such bonds should theoretically be valued using option pricing techniques, although this is not always done in practice.
* The value of the option will be greater, the more likely it is that the option will be exercised.
Suggest 5 ways of valuing equities
- Market value
- Dividend discount model
- Net asset value per share
- Value added measures
- Measurable key factors
Discuss market value as a method of valuing equities
The starting point for valuation of an individual equity is the market value, if there is a suitable market.
For most shares, this will be a simple and objective means of valuation
Discuss the dividend discount model as a method of valuing equities
The dividend discount model derives the value of a share as the discounted value of the estimated future dividend stream.
The general model can be expressed as:
V = sum(Dtvt) where the sum is for all t=1 to infinity
and where:
* V is the value of the share
* Dt is the gross amount of the t^th dividend payment
* Vt is the discount factor applied between time 0 and the time of the t^th dividend payment
The simplified model assumes that:
* dividends are payable annually, with the next payment in one year’s time
* dividends grow at a constant rate, g, per annum
* the required rate of return, i, is independent of the time at which paymetns are received
* i > g
* i and g are defined consistently - e.g. both include inflation or are net of inflation
* the dividend proceeds can be reinvested at i p.a.
* no tax and expenses
* It is also assumed that shares are held forever, as per the general model
Therefore, it can be expressed as:
V = D/(i-g) or V = D0(1+g)/(i-g)
where D0 is the most recent dividend received,
and where:
* V is the value of the share
* D is the dividend in exactly one year’s time
* i is the investor’s required rate of return
* g is the dividend growth rate
Discuss net asset value per share as a method of valuing equities
A NAV per share approach can be adopted for companies with significant tangible assets.
A similar approach can be adopted to shares of a property investment company.
Such an approach would not give a realistic value for companies whose value comprises significant intangible assets.
A NAV per share approach might be used to value an investment trust company where the underlying assets may have valuations in their own right.
Discuss value added measures as a method of valuing equities
Shareholder value is an attempt to get at the intrinsic 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.
What is EVA?
EVA is broadly determined as operating profits over one year less the cost of capital surrounding those results
It’s an attempt to get at the ‘value added’ by the company over the specific year.
Discuss other equity valuation methods
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.
The methods discussed all implicitly assume:
* the company is declaring dividends and/or
* it is making profits and/or
* net asset valuation is suitable
But this will not always be the case, for example, if the company is young and yet to declare any dividends, is making losses or has few tangible assets.
Other methods must then be used to assess the value of the shares in the company in question.
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 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:
1. lack of marketability
2. risk of voids
3. default risk
4. volatility of market value and illiquidity
5. indivisibility
6. depreciation and obsolescnece
7. costs
List 2 methods of valuing swaps
- Discounted cashflow of income - outgo
- As the sum of a series of forward arrangements
Discuss the valuation of options, futures and swaps
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.
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 discoutn rate should vary by type of asset/liability or by term of each asset/liability cashflow
Discuss whether volatility of asset values is a problem
Volatility of asset value is often stated as the main problem with market vaue 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.
