Chapter 13 - Valuation of Investments Flashcards
8 Valuation methods
BOOK VALUE
- (historical) book value
- written up or written down book value
MARKET VALUE
- market value
- smoothed market value
- fair value
- arbitrage value
DISCOUNTED CASHFLOW
- discounted cashflow (deterministically calculated)
- most common method
- stochastic modelling
Fair value
the amount for which an asset could be exchanged or a liability settled between KNOWLEDGEABLE, WILLING parties at ARM’S LENGTH.
What are the characteristics of market value as a valuation proxy?
Market values are generally
…. easily available,
…. objective and
…. well-understood.
However, they can be volatile in the short-term.
It can also be difficult to value liabilities in a consistent, market-based manner.
Bond valuation
Present value of coupon and redemption payments.
Each cashflow is discounted at the market spot rate of the appropriate term, adjusted for:
- Risk of default
- Marketability
- Additional option features should theoretically be valued using option pricing techniques
Discounted dividend model
Derives the value of a share as the discounted value of the estimated future dividend stream.
Value = D/(i-g),
where D = D_now(1+g),
D is the dividend payable in one year from now.
Issues:
- how to determine i: Req return = RFRnominal + ERP (what is Equity Risk Premium?)
- how to determine g, subjective if not currently paying
- allowing for tax
- sensitivities of Value wrt (i-g)
- frequency of dividend payment
3 Equity valuation methods
• SHARE ANALYSIS (Ratios) / RELATIVE VALUATION METHOD
- — P/E Ratios
- — P/S Ratio
- — Price to NAV ratio
- — Other ratios - relevant and measurable
• VALUE ADDED MEASURES
- — EVA (Economic Value Added)
- — PV[EVA]
(note: EVA = profit - cost of capital)
• DISCOUNTED DIVIDEND MODEL
Property valuation
Discounted cashflow approach is mostly used
Explicit allowance for:
- rent frequency
- rental increases
- expenses
- possibility of voids
- term of the lease
- redevelopment / refurbishment costs
- discount rate = yield of bond with suitable term + margins for risk(s) & lack of marketability.
- difficulty in setting suitable discount rate, since risks and other factors are difficult to quantify.
Relative Valuation method might also be used:
Price = Rent per annum x Suitable Capitalization Factor (P/Rent Ratio)
Options & futures valuation
Usually valued using techniques based upon the principle of no-arbitrage, (option pricing methods)
Valuation of swaps
Valued by discounting the 2 component cashflows (ex fixed for floating).
At inception, the value (at market rates of interest) of a swap to both parties will be zero, ignoring the market maker’s profit and expenses.
As market interest rates change, the value of the 2 cashflows will alter, leading to a positive net value for one party and a negative net value to the other.
Historic book value
Price originally paid for the asset and is often used for fixed assets in published accounts.
(inappropriate for liability valuation, the appropriate discount rate cannot be determined)
Favorability of the (historic) book value method
It is:
- objective
- conservative
- well-understood & easy to obtain
- used for some accounting purposes
Written up or written down book value
Historic book value adjusted periodically for movements in value.
(inappropriate for liability valuation, the appropriate discount rate cannot be determined)
Smoothed Market value
Where market values are available, they can be smoothed to remove daily fluctuations (ex some form of average).
- smoothed market value does not lend itself to consistent liability valuations, since…
- discount rate for liability valuations are indeterminate and requires judgment.
(for there to exist a fair asset-liability valuation, both sides of the balance sheet needs to use the “same valuation basis” and be consistent. How can smoothed market value be used to value liabilities? Or historic book value to value liabilities? It struggles, since appropriate discount rate cannot be determined for the liability valuation)
Fair value calculation
For most assets, the fair value will simply be the market price.
If the market price of an asset is not readily available, then a proxy might be sought in the form of an alternative fair value.
- seek an indicative price from a broker or market maker
- use a stochastic asset model to determine a market-consistent value
- use most recent known price and adjust in line with the movement of an appropriate index.
Discounted cashflow
Involves discounting the expected future cashflows from an investment, using long-term assumptions.
- subjective
- easy to obtain and consistent with liability valuation.
- appropriate discount rate might not be simple to derive
