1
Finance School of Management
Objective
Explain the principles of
asset evaluation
Chapter 7,Principles of Asset
Valuation
2
Finance School of Management
Chapter 7 Contents
? 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
? The law of one price &
arbitrage
? Interest rates & the law
of one price
? Exchange rates &
triangular arbitrage
? Valuation using
comparables
? Valuation Models
3
Finance School of Management
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 (M&A)
– Others
4
Finance School of Management
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,
5
Finance School of Management
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,
A s s e t s
L a nd $25,000
B ui l di ng 75,000
L i abi l i t i e s
M or t a ga ge L oa n 80,000
O w ne r ’ s E qui t y ( N e t W or t h) 20,000
A B C R e al t y B al an c e S h e e t
J a nua r y 1,19X 0
A s s e t s
L a nd & B ui l di ng $15 0,000
L i abi l i t i e s
M or t a ga ge L oa n 80,000
O w ne r ’ s E qui t y ( N e t W or t h) 70,000
A B C R e al t y M ar k e t - V al u e B al an c e S h e e t
J a nua r y 2,19X 0
6
Finance School of Management
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,
7
Finance School of Management
Efficient Market Hypothesis (EMH)
? An asset’s current price fully reflects all
publicly available information about
future economic fundamentals affecting
the asset’s value,
8
Finance School of Management
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)
– Determining the extent of dispersion around the
estimate (risk)
– Risk-return trade-off,budget limitation and
investment decision or recommendation
1
P ( 0 )
( 1 )Pr ??
9
Finance School of Management
– 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,
— Aggregation of all analysts’ estimates
How Does the Market Pool the Information Pieces
10
Finance School of Management
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,
11
Finance School of Management
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,
12
Finance School of Management
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 using futures),
– Delay paying for the gold you purchase until you receive
payments from selling it (by short-selling),
? 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,
13
Finance School of Management
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,
14
Finance School of Management
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,
15
Finance School of Management
Arbitrage,Exchange Rates
?You walk into a bank and observe three
exchange rates—$0.01/ ￥,￥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
$210,
?Professional arbitrageurs can execute large
arbitrage transactions at,windows” on their
computer screens via an electronic hookup to
other banks located almost anywhere in the
world,
?Arbitrage ensures
that for any three
currencies that are
freely convertible
in competitive
markets,it is
enough to know
the exchange rates
between any two
in order to
determine the
third,
16
Finance School of Management
Triangular Arbitrage
USA Japan
UK
￥100/$ or $0.01/￥
￡0.005/￥ or ￥200/￡ $2/￡ or ￡0.5/$
17
Finance School of Management
Triangular Arbitrage
? More generally,
RA/C = RA/B * RB/C
RA/B = 1/RB/A
18
Finance School of Management
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,
19
Finance School of Management
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,
20
Finance School of Management
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,
21
Finance School of Management
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
22
Finance School of Management
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
Finance School of Management
Objective
Explain the principles of
asset evaluation
Chapter 7,Principles of Asset
Valuation
2
Finance School of Management
Chapter 7 Contents
? 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
? The law of one price &
arbitrage
? Interest rates & the law
of one price
? Exchange rates &
triangular arbitrage
? Valuation using
comparables
? Valuation Models
3
Finance School of Management
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 (M&A)
– Others
4
Finance School of Management
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,
5
Finance School of Management
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,
A s s e t s
L a nd $25,000
B ui l di ng 75,000
L i abi l i t i e s
M or t a ga ge L oa n 80,000
O w ne r ’ s E qui t y ( N e t W or t h) 20,000
A B C R e al t y B al an c e S h e e t
J a nua r y 1,19X 0
A s s e t s
L a nd & B ui l di ng $15 0,000
L i abi l i t i e s
M or t a ga ge L oa n 80,000
O w ne r ’ s E qui t y ( N e t W or t h) 70,000
A B C R e al t y M ar k e t - V al u e B al an c e S h e e t
J a nua r y 2,19X 0
6
Finance School of Management
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,
7
Finance School of Management
Efficient Market Hypothesis (EMH)
? An asset’s current price fully reflects all
publicly available information about
future economic fundamentals affecting
the asset’s value,
8
Finance School of Management
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)
– Determining the extent of dispersion around the
estimate (risk)
– Risk-return trade-off,budget limitation and
investment decision or recommendation
1
P ( 0 )
( 1 )Pr ??
9
Finance School of Management
– 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,
— Aggregation of all analysts’ estimates
How Does the Market Pool the Information Pieces
10
Finance School of Management
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,
11
Finance School of Management
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,
12
Finance School of Management
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 using futures),
– Delay paying for the gold you purchase until you receive
payments from selling it (by short-selling),
? 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,
13
Finance School of Management
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,
14
Finance School of Management
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,
15
Finance School of Management
Arbitrage,Exchange Rates
?You walk into a bank and observe three
exchange rates—$0.01/ ￥,￥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
$210,
?Professional arbitrageurs can execute large
arbitrage transactions at,windows” on their
computer screens via an electronic hookup to
other banks located almost anywhere in the
world,
?Arbitrage ensures
that for any three
currencies that are
freely convertible
in competitive
markets,it is
enough to know
the exchange rates
between any two
in order to
determine the
third,
16
Finance School of Management
Triangular Arbitrage
USA Japan
UK
￥100/$ or $0.01/￥
￡0.005/￥ or ￥200/￡ $2/￡ or ￡0.5/$
17
Finance School of Management
Triangular Arbitrage
? More generally,
RA/C = RA/B * RB/C
RA/B = 1/RB/A
18
Finance School of Management
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,
19
Finance School of Management
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,
20
Finance School of Management
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,
21
Finance School of Management
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
22
Finance School of Management
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
