Chapter 23: Valuation of individual investments

Question 1

8 Valuation methods

Answer 1

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)
• stochastic modelling

Question 2

Fair value

Answer 2

the amount for which an asset could be exchanged or a liability settled between KNOWLEDGEABLE, WILLING parties at ARM’S LENGTH.

Question 3

What are the characteristics of market value as a valuation proxy?

Answer 3

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.

Question 4

Bond valuation

Answer 4

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

Question 5

Discounted dividend model

Answer 5

derives the value of a share as the discounted value of the estimated future dividend stream.

Question 6

3 Equity valuation methods

Answer 6

• SHARE ANALYSIS

• — P/E Ratios
• — Other ratios - relevant and measurable

• VALUE ADDED MEASURES

• — EVA
• — PV[EVA]

• DISCOUNTED DIVIDEND MODEL

Question 7

Property valuation

Answer 7

Discounted cashflow approach is mostly used

Explicit allowance for:

• rent frequency
• rental increases
• expenses
• possibility of voids
• term of the lease
• redevelopment / refurbishment costs

Question 8

Options & futures valuation

Answer 8

Usually valued using techniques based upon the principle of no arbitrage, (option pricing methods)

Question 9

Valuation of swaps

Answer 9

Valued by discounting the 2 component cashflows.
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.

Question 10

Historic book value

Answer 10

Price originally paid for the asset and is often used for fixed assets in published accounts.

Question 11

Favourability of the (historic) book value method

Answer 11

It is:

• objective
• conservative
• well-understood
• used for some accounting purposes

Question 12

Written up or written down book value

Answer 12

Historic book value adjusted periodically for movements in value.

Question 13

Smoothed Market value

Answer 13

Where market values are available, they can be smoothed to remove daily fluctuations.

Question 14

Fair value calculation

Answer 14

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.

Question 15

Discounted cashflow

Answer 15

Involves discounting the expected future cashflows from an investment.

Question 16

Arbitrage value

Answer 16

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.

Question 17

Callable bond

Answer 17

bond that the borrower can choose to repay at any time.

Question 18

puttable bond

Answer 18

the investor can demand repayment at any time.

Question 19

Value of a puttable bond to the investor

Answer 19

Equal to that of an otherwise identical bond that does not include an option, plus the time value of the choice provided by the option.

Question 20

Valuing portfolios of shares

Answer 20

The valuation of a portfolio of ordinary shares would be carried out by assuming the shares were swapped for a holding in an index.

Question 21

Appropriate valuation method depends on (3)

Answer 21

• Objective of the investment
• Reasons for valuation
• Type of asset

Question 22

Valuation of assets make it possible to (2)

Answer 22

• Identify “value for money” investments

- Monitor experience of the investment portfolio

Question 23

7 Criteria for assessing asset valuation methods

Answer 23

• Readily available or not
• Subjective / objective
• Conservative / realistic
• Simple to obtain or complex to calculate
• How well is it understood
• Volatile or not
• Consistency with liability valuation

Question 24

Alternative way of viewing a swaps contract

Answer 24

As a series of forward contracts.

If each of these forward agreements can be valued, then so can the swap.

Question 25

Stochastic models as a valuation method

Answer 25

• They are an extension of the discounted cashflow
  method
• 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.

Question 26

Disadvantages of stochastic models for valuation

Answer 26

• they may be too complex for many applications
• the results are dependent on the assumed distributions
  for the variables - these assumptions may be highly
  subjective

Question 27

Arbitrage

Answer 27

The simultaneous buying and selling of two economically equivalent, but differently priced portfolios so as to make an instant and risk-free profit.