Chapter 23: Valuation of individual investments Flashcards
8 Methods of valuing assets
- Historical book value
- Written up/down book value
- Market value
- Smoothed market value
- Discounted cashflow
- Stochastic models
- Arbitrage value
- Fair value
Written up/down book value
The historical book value adjusted periodically for movements in value.
E.g. a property might be revalued.
Historic book value
The price originally paid for an asset, often used for fixed assets in the published accounts.
Stochastic modelling approach to valuing assets
An extension of the discounted cashflow method in which the future interest rates and/or cashflows are treated as random variables.
The result of such a valuation is a distribution of values from which the expected value or other statistic can be determined.
Particularly appropriate for valuing options / guarantees.
Fair value
The amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties at arm’s length.
Advantages of market value
- objective
- easily obtained
- well understood
Modern finance theory says that where a market value exists, it will reflect all publicly available information and is the underlying economic value of an asset.
Disadvantages of market value
- only known for certain when an asset is sold. Therefore for some infrequently traded, less liquid assets such as property, the true market value will often be unknown.
- market values are volatile, which makes it difficult to get consistency with the liability valuation if the liabilities are valued using a more stable long-term discounted cashflow approach.
Main advantage and disadvantage of the discounted cashflow method
Its easily consistent with liability valuation.
But the choice of discount rate is subjective.
Formula for the simplified discounted dividend model
V = D/(i-g)
V = value of the share D = prospective dividend payable in exactly one years time i = investor's required rate of return g = assumed rate of dividend growth
Assumptions underlying the discounted dividend model
- dividends are annual, with the next dividend in one year’s time
- i and g are constant, effective annual rates
- i > g
- i and g are either both nominal or both real
- tax and expenses are ignored
How else might you value equities
Using net asset values.
E.g. property companies or investment trust companies.
Measurable key factor approach
Used when a company does not have a quoted market value and most other methods are inappropriate.
Involves:
- finding a factor that represents how successful a company might be
- the relationship between this factor and the market value of quoted companies can be used as a basis for the value of the company in question
If we value property using a discounted cashflow approach, how would we use a suitable discount rate?
The discount rate would be based on the yield on a government bond of a suitable term, plus risk margins for:
- lack of marketability
- indivisibility
- obsolescence
- depreciation
- voids
- rental default
- volatility
How are options and future usually valued?
Based on the principle of no arbitrage.
You would find a replicating portfolio of investment to the one that you are trying to value.
You value the replicating portfolio and then apply the condition that in an efficient market, the value of your asset should be equal to the value of the replicating portfolio.
How would you value swaps?
You could discount the two component cashflows.
At inception, the discounted value, ignoring profit and expenses should be zero to both parties.
Over time, as market conditions change, the swap will have a positive value to one party and a negative value to the other.
Alternatively, you could value a swap as a series of forward agreements.
