Institutional Investment

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Institutional Investment

• Shane Whelan
• L527

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Continuation of Last Section - Valuation of
Individual Investments

• List of 8 valuation methods
• Bond Valuation by DCF
• Equity Valuation by DDM
• i D/(i-g)
• i dg
• Inevitably crude and must use other methods also
• Other Methods for Individual Equities

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Other Approaches/Measures to Share Valuation

• PER (or P/E ratio)
• Dividend yield
• Payout Ratio(PER x Dividend yield)
• NAV per share (NAVnet asset value)
• Value Added Measures EVA, MVA
• Sundry Others

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PER (or P/E ratio)

• P/E is defined as ordinary share price divided by
  earnings per share (eps).
• High ratio indicates that shares are highly
  valued for high (eps) growth in future or lower
  risk.
• For comparison ensure consistency in earnings
  historic, prospective. If earnings below normal
  (e.g. AIB) then must adjust in some way. What if
  loss made?
• Different sectors of market tend to have
  different P/E levels hence use primarily to
  compare companies in same sector.
• Usually look at fully diluted eps
• EPS are after tax

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Dividend yield

• Defined (obviously) as dividends per share
  divided by current share price.
• Calculated gross or net of tax.
• Low div. yield could mean that good dividend
  growth expected or is less risky (so also check
  dividend cover 1/Payout ratio
• Distorted if company passes on dividend or makes
  a special dividend
• Not so important as signal to investors as once
  was as companies are more prone to vary dividend
  downwards than they were in the past and
  renumerate shareholders in other ways.

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NAV per share

• NAV per share (share capital plus reserves less
  intangibles)/no. of shares in issue.
• Generally a meaningless measure as does not
  attempt to measure future income stream but
  important to value certain classes of company
• Investment trusts
• Property companies
• To a lesser extent
• Hotel chains, breweries, Ardagh
• It requires a market valuation of assets not the
  accounting value often given in balance sheets.

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Value Added Measures EVA, MVA

• Economic Value Added (EVA)
• EVANOPAT-(WACC times Net Assets)
• Where
• NOPAT Net Operating Profit After Tax
• WACC The Companys Weighted Average Cost of
  Capital of Enterprise Value in Debt times cost
  of debt (GRY) plus of Enterprise Value in
  Equity times return required by investors.
• Gives NAV of project undertaken by firm
• Net Assets Adjusted Value of Shareholders fund
• A fashion in analysis in mid/late 1990s. Jury is
  out on its usefulness.

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Value Added Measures EVA, MVA

• Market Value Added (MVA) is the difference
  between MV of company and its balance sheet value
  (MV-BV).
• View as value generated by management of the
  assets value market puts on companys EVA.
• Ratio MV to BV is reported to be a good indicator
  of value.

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Sundry Valuation Measures

• In the last few years many companies came to
  market with no dividends, no profits, and NAV of
  essentially nothing Amazon, Tech stocks
  (Riverdeep), mobile phones (Esat).
• So find some relevant and measurable key factor,
  find (hopefully) a consistent relationship
  between this key measure and the MV of other
  companies in the sector, and hence use it to
  value company
• E.g., for Esat use number of phone license
  agreements it has sold (handsets).

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Property Valuation

• Value of property is the discounted value of the
  rent (less costs) that it can reasonably achieve.
  Experienced valuers estimate
• Rack rent
• Rental yield for similar properties in area,
  tweaked as appropriate
• Hence MVrack rent/appropriate rental yield
• You go to first principlesuse DCF on net
  proceeds
• Current rent, next rent review, current rack
  rent.
• Allow for residual value at expiry of lease,
  depreciation, running costs (e.g., 3 of rents),
  voids (e.g., 2 reduction in rents)
• Growth in rack-rents

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Property Valuation

• The valuation rate of interest reflects GRY on
  long bond, plus margin for risk depending on
  property plus margin for illiquidity.
• So factors on individual property to consider..
• Use, and possibility of alternative use,
  development potential
• Location
• Nature of lease especially covenant of tenant
• Quality of building
• Other factors
• Shop or office in good location mught be bond
  yield plus 2-4.

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Question Valuing a leasehold Interest

• Calculate the PV of the following head lease
• Remaining term 40 years
• Open market rent review 20 years from now
• Current rent 10,000 p.a., annually in advance to
  freeholder
• Rack rent 15,000 p.a. (annually in advance)
• Property recently let on 40 year sub-lease with
  rent reviews every 4 years.
• Assume rack rents increase at 5 p.a.. Use a
  valuation rate of 10. State any further
  assumptions you make.

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Valuation of Convertibles

• There are 4 distinct approaches to the valuation
  of convertibles.
• DCF
• Comparison with share price
• Comparison with loan stock or preference share
  -if conversion is at your discretion then mimimum
  value is the value of an equivalent loan stock
  issued by company
• Option value method

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Convertibles DCF approach

• The Mechanics
• Value fixed income stream until conversion of
  shares
• From conversion date value the stream of
  dividends
• Choose the conversion date to maximise PV (if you
  can exercise the option to convert)which is the
  date the dividend stream exceeds the fixed
  income.
• Write down equation.
• A Critique
• All caveats of DDM
• Time value of option not evaluated
• Careful with tax as sometimes different rates on
  dividends and coupons.

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Convertibles Comparison with Share

• Value of convertible value of equity shares to
  which it converts plus value of income
  differential before conversion.
• Write down formula.
• A Critique
• If we take value of share as its current market
  price then the above formula gives a good
  comparison of whether convertible is dear or
  cheap relative to the shares.
• If we take value of share as its DDM value then
  it is the same value as the DCF approach (under
  same assumptions)
• Time value of option not evaluated.
• Careful with tax as sometimes different rates on
  dividends and coupons.

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Convertibles Option Value Method

• Previous methods to not allow for the time value
  of the option.
• Value of Convertible Value of loan stock plus
  option to buy shares at any future time at the
  then market value of the loan stock.
• So option value is greater the greater the
  volatility of the stock and the more it is
  out-of-the-money.

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Valuation of Futures Options

• Valuation methodology based on the law of one
  price and a suitable replicating portfolio of
  marketable assets. No arbitrage principle.