CHP 23

Question 1

Valuation of individual investments

Answer 1

If assets are traded on the open market and open market prices are available, this will form the reference point for all valuations. If there are no open market prices, other methods must be used as proxy.
After establishing a market value (or proxy of this) one can then decide to do a valuation to suit the need. If the purpose is an overall valuation of assets and liabilities the basis for valuation must be consistent.

Question 2

1. Valuation methods for individual investments

1. 1. (Historic) book value

Answer 2

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

Question 3

1. Valuation methods for individual investments

1. 2. Written up or written down book value

Answer 3

Historic book value periodically adjusted for movements in value.
Neither of these offer a consistent liability valuation basis – the appropriate discount rate for the liability valuation cannot be determined.

Question 4

1. Valuation methods for individual investments

1. 3. Market value

Answer 4

Market value of an asset varies over time, this value is only known for certain when the asset changes hands. Even in the open market, more than one figure could be quoted at any time.
For many traded securities it is an objective value that is easy to get and offers a good starting point for valuation.

Question 5

1. Valuation methods for individual investments

1. 4. Smoothed market value

Answer 5

Market values can be smoothed to remove daily fluctuations, e.g. by taking a running average.
This method does not lend itself to consistent liability valuations (appropriate discount rate cannot be determined and requires judgment).
In practice the assessment becomes a view as to whether the asset is cheap or dear in relation to the smoothed value.

Question 6

1. Valuation methods for individual investments

1. 5. Fair value

Answer 6

Fair value is the value that an asset or liability can be settled by two willing parties at arm’s length. The definition does not specify the method for valuation.
For most assets, this will be market price.

Question 7

1. Valuation methods for individual investments

1. 6. Discounted cashflow

Answer 7

Value an asset by discounting all future cashflows from an investment.
Advantage: This method can easily be made consistent with method used for valuing liabilities.
However, this method relies on an appropriate discount rate being chosen, easier for some than for others (e.g. high quality fixed-interest stocks).

Question 8

1. Valuation methods for individual investments

1. 7. Stochastic models

Answer 8

This is an extension of the discounted cashflow model, the future cashflows, interest rates or both are considered random variables.
The result of a stochastic valuation gives a distribution of values from which the expected value and other statistics can be found.
This method is especially important in complicated cases where future cashflows are dependent on the exercise of embedded options, e.g. the option wind up in adverse financial circumstances.

Question 9

1. Valuation methods for individual investments

1. 8. Arbitrage value

Answer 9

This is a method of obtaining a proxy for market value of an asset. It is calculated by replicating the investment by a combination of other investments and applying the efficient market condition of equality of assets.

Question 10

1. Valuation methods for individual investments

1. 9. Market values compared with calculated values

Answer 10

Modern finance states that where efficient markets exist, the market value takes into account all public information available and is the underlying economic value at a given point in time.
Market values can be subject to considerable movements in value – this depends on market sentiment and conditions, it can be argued that it hides the true underlying intrinsic value of the asset.
The counter argument is that using another method to identify the intrinsic value requires an investment call to be made on the direction of the market in that asset.

Question 11

A market method or a calculated method can be used as a filter for selecting shares for sale or purchase for further consideration.

Answer 11

In practice other factors will be taken into account before trading decisions are made.
If a value other than market value is used, it is important to make the implications of this clear to the client. This is particularly true when short-term solvency is considered.

Question 12

2. Bond valuations

Answer 12

Government or similar high-quality bonds can be valued by discounting cashflows at the market spot yield curve.
Corporate bonds can be valued similarly but adjusting the yield to allow for lower security and marketability.
Many bonds have option features, these should be valued using option pricing techniques – this is not always done in practice.

Question 13

Valuing portfolio of shares

Answer 13

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

Question 14

3.2. Dividend discount model

Answer 14

This model derives the value of a share by discounting the estimated future dividend stream.

Question 15

3.2. Dividend discount model

Simplified model

Answer 15

Assume:
• Dividends are paid 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 payments are received.

Question 16

Issues to consider when applying the simplified DDM model:

Answer 16

• We do not know the value of i to use in the model and the constant i assumption may be inappropriate.
• We do not know what g should be. In practice a constant rate may not be realistic, use profit forecasts to predict dividend in the next few years then apply a short-term rate of growth until long term average settles down.
• Results obtained are very sensitive to the selected i and g.
• The equation ignores tax. Use a net dividend received if tax needs to be paid.
• The model assumes annual dividend. In practice there are other frequencies – this is not a major assumption as there are much more drastic things assumed.

Question 17

3.3. Determination of i DDM

Answer 17

Use the yield on government bonds plus a margin for riskiness of the income stream.
Investors with real liabilities might start from an index-linked government bond yield and estimate the real, rather than nominal, rate of dividend growth.

Question 18

3.4. Determination of g DDM

Answer 18

Use a model to predict the company’s future outlooks.

Question 19

3.6. Value added measures of equities

Answer 19

Shareholder value is an attempt to get the intrinsic (or underlying) value of an investment rather than its accounting value.
EVA (Economic Value Added) – looks at one year’s results and deducts the cost of servicing the capital that supports those results.
EVA acts as a bridge between quoted share values and accounting values to give a framework for executive compensation schemes designed to produce results that increase shareholder value.

Question 20

3.7. Other equity valuation methods

Answer 20

Where companies are not making profits and a net asset valuation is not appropriate, employ other methods to calculate a valuation.
These methods often involve determining a relevant and measurable key factor of the company’s business. The relationship between this factor and the market price of other companies is then used as a basis for valuation.
The factor used will depend on the particular business of the company.

Question 21

3.8. Property valuation

Answer 21

Property valuation can be done by explicit discounted cashflow approach.
The cashflows should be net of all outgo and should make explicit allowances for the expected rate of rental increases.
If the property is rented below market value or above market value, this should be taken into account. Also take into account terms of the rental agreement (e.g. downward revision of rent).
Discount rate should take into account riskiness of the asset, variability of the rent, lack of marketability of the property.

Question 22

3.9. Valuation of options and futures

Answer 22

Usually principle of no arbitrage is used to value these. The value taken is the cost of closing out the contract.

Question 23

3.10. Valuation of swaps

Answer 23

Swaps can be valued by discounting the two component cashflows. At inception the value (at market rates of interest) of the swap will be zero for both parties – ignoring the market maker’s profit and expenses.
As market rates (or exchange rates) change, the value of the two cashflows will also change. This will lead to a positive net value for the one party and a negative net value for the other. Even if rates don’t differ from what was expected, the value of the swap is likely to be positive for parts and negative for other parts.
A swap can be viewed as a series of forward agreements. If each of these can be valued, the swap can also be valued.