Chapter 7: Principles of Asset Valuation

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Chapter 7 Principles of Asset Valuation
Objective Explain the principles of asset
evaluation
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Chapter 7 Contents

• The relationship between an assets value price
• Value maximization financial decisions
• Accounting measures of value
• How information is reflected in security prices
• The efficient markets hypothesis

• 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

• The process of estimating how much an asset is
  worth.
• At the heart of much of financial decision
  making
• Investing in securities
• Investing in real estate
• Wealth (value) maximization
• Venture capital
• Financing
• Mergers and acquisition (MA)
• Others

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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

• 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.

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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 assets current price fully reflects all
  publicly available information about future
  economic fundamentals affecting the assets value.

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How Does the Market Pool the Information Pieces
A typical analyst-investors decision making

• Collecting the information or facts
• Determining the best estimate (expectation)
• 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 ones 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

• 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
  rates0.01/ , 200/, and 2.1/.
• What should you do?
• At the / window, convert 200 into 20,000.
• At the / window, convert 20,000 into 100.
• At the / window, convert 100 into 210.
• Professional arbitrageurs can execute large
  arbitrage transactions at windows on their
  computer screens via an electronic hookup to
  other banks located almost anywhere in the world.

• Arbitrage ensures that for any three currencies
  that are freely convertible in competitive
  markets, it is enough to know the exchange rates
  between any two in order to determine the third.
  

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Triangular Arbitrage
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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 assets 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 Firms Stock (its
  most recent) Earnings Per Share (EPS)
  Price/Earnings Multiple (derived from comparable
  firms).
• XYZs 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
• XYZs EPS Industrial Average P/E Multiple
  210 20
• Further notes on Comparable debt/equity
  ratios, growth opportunities