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Chapter 7: Principles of Asset Valuation


Chapter 7: Principles of Asset Valuation Objective Explain the principles of asset evaluation Chapter 7 Contents The relationship between an asset s value & price ... – PowerPoint PPT presentation

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Title: Chapter 7: Principles of Asset Valuation

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

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

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.

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.

Market Price Fundamental Value
QRS Pharmaceuticals Corporation
  • How is the stock market reacting to the
  • 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

Efficient Market Hypothesis (EMH)
  • An assets current price fully reflects all
    publicly available information about future
    economic fundamentals affecting the assets value.

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

How Does the Market Pool the Information Pieces
Aggregation of all analysts estimates
  • Differing abilities to access and process the
  • 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

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
  • 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

Arbitrage The Price of Gold
  • The price of gold in New York City is 300 per
  • 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.

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
  • 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
  • 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
  • The lower the transaction costs, the narrower the

Arbitrage The Price of GM Shares
  • Shares of GM are traded on both the New York
    Stock Exchange (NYSE) and on the London Stock
  • 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.

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.

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.

Triangular Arbitrage
Triangular Arbitrage
  • More generally,
  • RA/C RA/B RB/C
  • RA/B 1/RB/A

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.

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.

Valuation Using Comparables
  • No two distinct assets are identical in all
  • 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

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.

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
  • 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
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