1 Chapter 7: Principles of Asset Valuation Copyright © Prentice Hall Inc Author: Nick Bagley, bdellaSoft, Inc. Objective Explain the principles of asset evaluation

2 Chapter 7 Contents 1. The relationship between an asset’s value & price 2. Value maximization & financial decisions 3. The law of one price & arbitrage 4. Arbitrage & the prices of financial assets 5. Interest rates & the law of one price 6. Exchange rates & triangular arbitrage 7. Valuation using comparables 8. Valuation Models 9. Accounting measures of value 10. How information is reflected in security prices 11. The efficient markets hypothesis

3 Fundamental Value of an asset The price that well-informed investors must pay for the asset in a free and competitive market

4 Value Maximization and Financial Decisions  The financial decision can rationally be made purely on the basis of value maximization, regardless of risk preferences or expectations about the future.  The market for financial assets provides the information needed to value the alternatives.

5 How to estimate the values?  Look up the market price of the asset.  For assets that are not traded in any market, estimate the value using market prices of comparable assets.

6 The law of One price and Arbitrage  The Law of One Price: In a competitive market, if two assets are equivalent, they will tend to the same market price.  Arbitrage: The purchase and immediate sale of equivalent assets in order to earn a sure profit from the difference in their prices.

7 Arbitrage and the prices of financial assets Suppose shares of GM are traded in NYSE for $54 and in LSE on $56. Then  Arbitrageurs could earn sure profits by buying shares on NYSE and selling them immediately in LSE, but  Such arbitrage opportunities do not persist for very long.

8 Interest rates and the law of one price  If there are entities that have the ability to borrow and lend on the same terms at different interest rates, then they can carry out interest rate arbitrage.

9 Triangular Arbitrage USA Japan UK ¥100/$ or $0.01/¥ £0.005/¥ or ¥200/£ $2/£ or £0.5/$

10 Triangular Arbitrage  More generally  R A/C = R A/B * R B/C  R A/B = 1/R B/A

11 Triangular Arbitrage  More specifically, in the example  R £/¥ = R £/$ * R $/¥ = 0.5 * 0.01 =  R ¥/£ = 1/R £/¥ = 1/0.005 = 200  The other two pair follow the same form

12 Valuation Model  The quantitative method used to infer an asset’s value from information about the prices of comparable assets. It varies with the information available and the intended use of the estimated value.

13 Accounting Measures of Value  The book value of an asset or a liability as reported in a firm’s financial statement often differs from its current market value. Accountants usually measure assets by their original cost and then depreciate over the time according to rules that ignore market values.

14 The Efficient Market Hypothesis  An Asset’s Current Price Fully Reflect All Publicly Available Information About Future Economic Fundamentals Affecting the Asset’s Value.

15 Analysts’ estimates of the prices may differ for two reasons  They could have access to different amounts of information; or  They could analyze the information differently with regard to its impact on future prices.

16 EMH  The market price of the asset will reflect a 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.

17 As an analyst, you find a stock which you believe is a bargain There are two possibilities: 1. You do have a bargain-your estimate is more accurate than the market’s (i.e., you have either better than average information about future events that may affect price and/or you do a better than average job of analyzing information) or

18  Others have better information than you do or process available information better, and your bargain is not a true bargain.

19 The Quality of Financial Analysts are high, because  Rewards to anyone who can consistently beat the average, attracts intelligent people to the business.  Ease of entry into the business implies that competition will force analysts to do their best just to survive.  Stock market has been around long enough for these competitive forces to take effect.