Valuation And Asset Returns Flashcards
What is the difference between a financial and a real asset
Real assets: create goods and services, reflects productive capacity of the economy. Eg land, building, machines, IP. Generate net income in the economy.
Financial assets: do not contribute directly to the productive capacity of the economy. Eg shares and bonds. Means by which individuals hold claim on real assets. Financial assets define allocation of income or wealth
Fixed income or debt securities
Promise a fixed stream of income or a stream of income determined by a specific formula
Equity, shares, common stock
An ownership share in a corporation. Not promised a particular payment. Receive any dividends paid and prorated ownership of real assets.
Derivatives
Provide payoffs dependent on the prices of other assets such as stock and bond prices
Price weighted average calculation of an index
Add up all stock prices and divide by number of stocks
Higher priced stocks will dominate the value. Eg DJIA 30 stock index
Adjustments have been made to DJIA to reflect stock slits etc. the divisor may be adjusted to leave the overall index value unaffected. DJIA has also been adjusted over time for change in industry make up.
Nikkei 225 is also price weighted
Market value weighted index
Uses market value weighting of shares
Unaffected by stock splits
Higher weight to the stock with the higher value
Equally weighted index
Place equal weight on each stock’s return
Unlike price and value weighted indices, this is not appropriate for buy and hold approach because of adjustments that need to be made to maintain an equal weight.
Number of stocks is fixed, but composition can change
Total return index
Also known as accumulation index, includes dividends
Calculate S&P/ASX price index
Today’s closing price index = yest’ closing price index x today’s closing AMV/ yest closing AMV
Market weighted, so larger companies have a greater influence.
For total return calculation, include dividends in the numerator
Value in use
Value of an asset is derived from the future cashflows expected from owning it. Every asset, financial and real, has a value
Valuation myths
Since valuation models are quantitative, valuation is objective
A well researched and well done valuation is timeless
A good valuation provides a precise estimate of value
Te more quantitative the model, the better the valuation
To make money on valuation, you need to assume markets are inefficient
Product of valuation ie the value, is what matters, the process of valuation is not important
Time value of money
Discounted cash flow
Discounted cash flow:
Sum of CF/(1+r)^t
Time value of money is due to opportunity of investing today at a positive rate of return. $1 can be invested at 1.00 x (1+r)
Equity valuation
Value just the equity stake in the business
Calculate value of equity
discount cashflows to equity at the cost of equity
Calculate Value of Firm
Discount cashflows to the firm at the cost of capital (WACC)
Weighted Average Cost of Capital
WACC = Cost eq x (Eq/D+E)) + Cost debt (D / (D+E))
Relative Valuation definition; uses ratios such as:
RV determines the value of an asset by relating it to the known value of comparable assets
Ratios include:
P/E, P/Sales; P/BV
Contingent Claim Valuation
Many assets have option like features from: - trazding options - financial claims (eg equity) - real options EG - technology company with patents
Contingency Claim Valuation - why not used for all assets?
- Inputs difficult to estimate
- How to estimate strike prices
Real options valuation
Apply option pricing methods to the valuation of capital investments in real assets.
Situations where DCF is difficult to apply (7)
this is exam tip
- Firms in trouble (-ve earnigns & CFs)
- Cyclical firms (need to smooth CFs for the cycycle)
- Firms with unutilised assets
- Firms with patents or product options
- Firms in process of restructuring (change in CF profile)
- Firms involved in acquisitions (is there synergy / can this be estimated, impact of changing mgmt)
- Private firms (availabiltiy of information)
Studies in Real Options
this is an exam tip
- Abandonment (option to stop use of the assets, realising the salvage value)
- Flexibility to switch (option to alter output or input mixes in repsonse to changes in prices or demand
- Enter and exit (Option to exit an investment activity and reenter as conditions become more favourable
- Right to defer (option to delay invetsment outlays until such time that the investment is profitable
- STaged Investment (Option to make investment outlays in successive stages with the right to abandon the project as more information becomnes available
- Growth (option to capitalise on an earlier investment, such as one in research and development, to enter into related invedstment projects
- Interacting options (multiple options, including the option to defer, expand and switch)
What determines market rate of interest (4)
- Expected real rate of interest
- Expected inflation rate
- Expected risk premium
- Expected liquidity premium
Define expected real rate of interest (component of market rate of interest)
The rate which equates supply with demand for fundcs (in the absence of inflation & risk).
Define expected inflation rate (component of market rate of interest)
Compensation for any loss in purchasing power
eg 4% = interest, 5% = inflation. Therefore require: (100 x 1.04) x (1.05) = 109.2 to cpmpensate for $100n lent. Rate of nnominal interestn = 109.2/100-1 = 9.2%
Define expected risk premium (component of market interest rate)
Specific risk (operating, financial, management, collateral); and market risk
Define expected liuqiditry premium (component of market interest rate)
The effect of the term of the loan on the nominal interest rate
Borrowers prefer to lend long to avoipd need to frequently roll over borrowings. To avoid the risk, will pay higher yields
Standard deviation (define)
Symmetrical measure of dispersion; how far away from the mean we can expect our results to be
Risk premium (define_)
Risk premium is compensation for lending funds / investing. Reflects the risk that the return will be different from what is promised or expected
Excess return (define)
Return earned above a risk free rate
Calculate value of equity
discount cashflows to equity at the cost of equity
Calculate Value of Firm
Discount cashflows to the firm at the cost of capital (WACC)
Weighted Average Cost of Capital
WACC = Cost eq x (Eq/D+E)) + Cost debt (D / (D+E))
Relative Valuation definition; uses ratios such as:
RV determines the value of an asset by relating it to the known value of comparable assets
Ratios include:
P/E, P/Sales; P/BV
Contingent Claim Valuation
Many assets have option like features from: - trading options - financial claims (eg equity) - real options EG - technology company with patents
Contingency Claim Valuation - why not used for all assets?
- Inputs difficult to estimate
- How to estimate strike prices
Real options valuation
Apply option pricing methods to the valuation of capital investments in real assets.
Situations where DCF is difficult to apply (7)
this is exam tip
- Firms in trouble (-ve earnigns & CFs)
- Cyclical firms (need to smooth CFs for the cycycle)
- Firms with unutilised assets
- Firms with patents or product options
- Firms in process of restructuring (change in CF profile)
- Firms involved in acquisitions (is there synergy / can this be estimated, impact of changing mgmt)
- Private firms (availabiltiy of information)
Studies in Real Options
this is an exam tip
- Abandonment (option to stop use of the assets, realising the salvage value)
- Flexibility to switch (option to alter output or input mixes in repsonse to changes in prices or demand
- Enter and exit (Option to exit an investment activity and reenter as conditions become more favourable
- Right to defer (option to delay invetsment outlays until such time that the investment is profitable
- STaged Investment (Option to make investment outlays in successive stages with the right to abandon the project as more information becomnes available
- Growth (option to capitalise on an earlier investment, such as one in research and development, to enter into related invedstment projects
- Interacting options (multiple options, including the option to defer, expand and switch)
What determines market rate of interest (4)
- Expected real rate of interest
- Expected inflation rate
- Expected risk premium
- Expected liquidity premium
Define expected real rate of interest (component of market rate of interest)
The rate which equates supply with demand for fundcs (in the absence of inflation & risk).
Define expected inflation rate (component of market rate of interest)
Compensation for any loss in purchasing power
eg 4% = interest, 5% = inflation. Therefore require: (100 x 1.04) x (1.05) = 109.2 to cpmpensate for $100n lent. Rate of nnominal interestn = 109.2/100-1 = 9.2%
Define expected risk premium (component of market interest rate)
Specific risk (operating, financial, management, collateral); and market risk
Define expected liuqiditry premium (component of market interest rate)
The effect of the term of the loan on the nominal interest rate
Borrowers prefer to lend long to avoipd need to frequently roll over borrowings. To avoid the risk, will pay higher yields
Standard deviation (define)
Symmetrical measure of dispersion; how far away from the mean we can expect our results to be
Risk premium (define_)
Risk premium is compensation for lending funds / investing. Reflects the risk that the return will be different from what is promised or expected
Excess return (define)
Return earned above a risk free rate
Different valuation methods, name 3
- Discounted cashflow
- Relative valuation
- Contingent claims (options)
