Download Chapter 7: Principles of Asset Valuation

Finance
School of Management
Chapter 7: Principles of Asset
Valuation
Objective
Explain the principles of
asset evaluation
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Finance
Chapter 7 Contents

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The relationship between
an asset’s value & price
Value maximization &
financial decisions
Accounting measures of
value
How information is
reflected in security
prices
The efficient markets
hypothesis
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The law of one price &
arbitrage
Interest rates & the law
of one price
Exchange rates &
triangular arbitrage
Valuation using
comparables
Valuation Models
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The Role of Asset Valuation
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
The process of estimating how much an asset is worth.
At the heart of much of financial decision making:
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Investing in securities
Investing in real estate
Wealth (value) maximization
Venture capital
Financing
Mergers and acquisition (M&A)
Others
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Finance
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The Principle of Asset Valuation

Arbitrage & Law of One Price: The prices of
equivalent assets must be the same.

Use information about one or more comparables
whose market prices we know.

Market price & fundamental value: The price of
well-informed investors must pay for it in a free
and competitive market.

Value maximization and irrelevance of risk
preference, consumption and expectations.
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Market Value & Book Value
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You buy a house for
$100,000 on January 1,
19X0 and rent it out to
make a profit.
You finance the purchase
with $20,000 of your own
money (equity financing)
and an $80,000 mortgage
loan from a bank (debt
financing).
On January 2, someone
makes you a bona fide
offer of $150,000, which
is the market value.
ABC Realty Balance Sheet
January 1, 19X0
Assets
Land
$25,000
Building
75,000
Liabilities
Mortagage Loan
80,000
Owner’s Equity (Net Worth)
20,000
ABC Realty Market-Value Balance Sheet
January 2, 19X0
Assets
Land & Building
$150,000
Liabilities
Mortagage Loan
80,000
Owner’s Equity (Net Worth)
70,000
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Market Price & Fundamental Value
— QRS Pharmaceuticals Corporation
 How is the stock market reacting to the information?
– Announcements of good news: QRS’ research scientists
have just discovered a drug that can cure the common
cold.
– Announcements of bad news: A judge has just ruled
against QRS Pharmaceuticals in a lawsuit involving the
payment of millions of dollars in compensation to
customers who bought one of its products.
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Efficient Market Hypothesis (EMH)

An asset’s current price fully reflects all
publicly available information about
future economic fundamentals affecting
the asset’s value.
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How Does the Market Pool the Information Pieces
— A typical analyst-investor’s decision making
– Collecting the information or ‘facts’
– Determining the best estimate (expectation)
P (1)
r
1
P(0)
– Determining the extent of dispersion around the
estimate (risk)
– Risk-return trade-off, budget limitation and
investment decision or recommendation
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How Does the Market Pool the Information Pieces
— Aggregation of all analysts’ estimates
– Differing abilities to access and process the information
– The total demand for shares of a company
– The ‘votes’ cast with dollars:
The market price of the stock will reflect the weighted
average of analysts’ opinions with heavier weights on
the opinions of those analysts with control of more than
the average amount of money and with better than
average amounts of information.
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How Does the Market Price Approach the
Fundamental Value
– The consequences of consistently overestimating the
accuracy of one’s estimates
– The enormous rewards to anyone who can consistently
beat the average
– The relative ease of entry into the analyst business
Precisely because professional analysts compete
with each other, the market price becomes a better
and better estimate of “fair value”, and it becomes
more difficult to find profit opportunities.
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Arbitrage: The Price of Gold
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The price of gold in New York City is $300 per ounce.
Suppose that the price of gold in Los Angeles was
only $250.
It takes a day to ship the gold by air from Los Angels
to New York.
The transaction costs of buying gold in Los Angels
and selling it in New York include the costs of
shipping, handling, insuring, and broker fees, which
account for $2 per ounce.
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Arbitrage: The Price of Gold
 If you can
– Lock in the selling price of $300 at the same time that you
buy the gold (by short selling).
– Delay paying for the gold you purchase until you receive
payments from selling it (by buying on margin).
 You will have engaged in a “pure”, riskless arbitrage transaction.
 Gold dealers, arbitrageurs will also discover the discrepancy and
buy as large as possible in Los Angels.
 The force of arbitrage maintains a relatively narrow band around
the price difference between the gold market in Los Angels and
the one in New York.
 The lower the transaction costs, the narrower the band.
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Arbitrage: The Price of GM Shares
 Shares of GM are traded
on both the New York
Stock Exchange (NYSE)
and on the London Stock
Exchange.
 If shares of GM stock
were selling for $54 a
share on the NYSE at the
same time they were
selling for $56 on the
London Stock Exchange,
what would happy?
 The transaction costs in
the market for financial
assets are much lower
than those for gold.
 The arbitrage
opportunities can not
persist for very long.
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Arbitrage: Interest Rates
 Competition in financial markets ensure that not only the
prices of equivalent assets are the same but also interest rates
on equivalent assets are the same.
 Interest rates on the U.S. treasure Bonds & World Bank
dollar-denominated debt (both are free of default risk).
 Interest-rate arbitrage: borrowing at the lower rate and
lending at the higher rate.
The arbitrageurs’ attempts to expand their activity will
bring about an equalization of interest rates.
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Arbitrage: Exchange Rates
You walk into a bank and observe three
exchange rates—$0.01/ ¥, ¥200/£, and $2.1/£.
Arbitrage ensures
that for any three
What should you do?
currencies that are
– At the $/¥ window, convert $200 into
freely convertible
¥20,000.
in competitive
– At the ¥/£ window, convert ¥20,000 into
markets, it is
£100.
enough to know
– At the $/£ window, convert £100 into
the exchange rates
$210.
between any two
Professional arbitrageurs can execute large
in order to
arbitrage transactions at “windows” on their
determine the
computer screens via an electronic hookup to
third.
other banks located almost anywhere in the
world.
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Triangular Arbitrage
¥100/$ or $0.01/¥
USA
Japan
UK
$2/£ or £0.5/$
£0.005/¥ or ¥200/£
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Triangular Arbitrage

More generally,
RA/C = RA/B * RB/C
RA/B = 1/RB/A
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Triangular Arbitrage
 More
specifically, in the example
R£/¥ = R£/$ * R$/¥ = 0.5 * 0.01 = 0.005
R¥/£ = 1/R£/¥ = 1/0.005 = 200
 The other two pair follow the same form.
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Seemly Violation to the Law of One Price
 If seemly identical assets were selling at different prices,
we would suspect
– Something was interfering with the normal operation of
the competitive market.
– There was some (perhaps undetected) difference between
the two assets.
 Illustrations: A dollar bill / four quarters
– Doing your laundry using washer & dryer.
– Paying for drinking at a beverage vending machine.
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Valuation Using Comparables
 No two distinct assets are identical in all aspects.
 Valuation: Finding comparable assets and making
judgments about which differences have a bearing on
their value to investors.
 Example: Valuing your parents’ house.
Even when the force of arbitrage cannot be relied
upon to enforce the Law of One Price, we still rely on its
logic to value assets.
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Valuation Models
The difficulties of finding equivalent assets
Valuation models: The quantitative methods
used to infer an asset’s value from information
about the prices of other comparable assets
and market interest rates.
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Example: Valuing Shares of Stock
 The Value of a Share of a Firm’s Stock = (its most recent)
Earnings Per Share (EPS) * Price/Earnings Multiple (derived
from comparable firms).
 XYZ’s earnings per share are $2, and comparable firms in the
same line of business have an average price/earnings multiple
of 10. Thus
Estimated Value of a Share of XYZ Stock =
XYZ’s EPS * Industrial Average P/E Multiple = $2*10 = $20
 Further notes on ‘Comparable’: debt/equity ratios, growth
opportunities…
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