Chapter 24: Valuation of asset classes and portfolios Flashcards
Expected return on government bonds
Gross Redemption Yield
Expected return on corporate bonds
Gross Redemption Yield
Expected return on Equities
Dividend yield + expected dividend growth
Expected return on property
Rental yield + expected rental growth
Required return on Government bonds
risk-free real yield + expected inflation + inflation risk premium
Required return on corporate bonds
risk-free real yield + expected inflation + bond risk premium
Required return on Equities
risk-free real yield + expected inflation + equity risk premium
Required return on Property
risk-free real yield + expected inflation + property risk premium
Corporate bond risk premium is needed to compensate the investor for… (3)
- inflation risk
- possible default
- marketability / liquidity
Equity risk premium is necessary to compensate the investor for… (3)
- possible default
- marketability / liquidity
- volatility of share prices and dividend income
Property risk premium is needed to compensate the investor for… (6)
- possible default on rent
- risk of voids
- lack of marketability / liquidity
- large unit size and indivisibility
- risk of depreciation and obsolescence
- high dealing and management expenses
Yield gap
Dividend yield on equities less the gross redemption yield on long-dated government bonds.
Reverse yield gap
Gross redemption yield less dividend yield.
GRD - d = inflation risk premium - equity risk premium \+ expected real dividend growth \+ expected inflation
To justify the government bond yields being above equity (dividend) yields, then one or more of (((4))) must hold:
- high uncertainty over future inflation
- a low equity risk premium
- high prospects for real dividend growth
- high expected inflation.
2 Main sources of variability of asset values
- short-term market movements
- a change in the asset mix.
Expected return equation
Expected return
= initial income yield
+ expected capital growth
Required nominal return equation
required nominal return
= required risk-free real yield
+ expected inflation
+ risk premium
An overseas market would be considered ““cheap”” if…
expected return in local currency
+ expected depreciation of home currency
> expected return in home currency
Define “cheapness”
Expected return (ER) > required return (RR)
Dependent on the views and requirements of individual investor:
- ER function of investor’s view of the future
- – Riskiness of asset
- – Investor’s requirements
- – Matching liabilities
- – Subjective view of the future
Expected vs. Required return:
Simplifying assumptions
- All investors want a real return
- All investors have the same investment time horizon
- Tax differences between investors can be ignored
- Reinvestment is possible at a rate equal to the total expected return on the asset
- Assets are fairly priced
Why, historically has the running yield for property been higher than good quality equities? (4)
- dividends should increase annually, whereas rents are reviewed less often
- dividend arguably have better growth prospects than rents
- property is much less marketable than equities
- property is available only in large, indivisible and consequently inflexible
7 Valuation Methods
Book Value:
- historical
- written up / down
Market Value:
- smoothed
- fair value
- arbitrage
Discounted Cashflows
- deterministically calculated
- stochastic modelling
Two main sources of variability of asset classes
- Short-term market movements
- Change in asset mix
To justify PROPERTY YIELDS being ABOVE government bond yields, one or more of the following must hold ((3))
- low expected future inflation
- very low prospects for real rental growth
- justifiably high risk premium for properties
3 Other tests of relative value that investment analysts also use from time to time
- yield norms
- index level and price charts
- yield ratios
Yield “norms”
For some asset categories, there might be a normal level or range.
When yields are below (above) the normal range, it implies that the asset may be dear (cheap).
Index Analysis and Price charts
Technical analysis is sometimes used to compare the value of asset groupings as well as individual assets.
Yield ratios
The yield ratio is sometimes used when assessing the relative price of equities and bonds. (GRY/d)
Two different valuation methods and best valuing method
- Discontinuance Valuation = Market Valuation
- Ongoing Valuation = Discounted Cashflow
