Finance School of management Chapter 7: Principles of asset Valuation Obiective Explain the principles of sset evaluation uesTc
1 Finance School of Management Objective Explain the principles of asset evaluation Chapter 7: Principles of Asset Valuation
Finance School of management Chapter 7 Contents The relationship between The law of one price an assets value price arbitrage Value maximization Interest rates the law financial decisions of one price Accounting measures of Exchange rates value triangular arbitrage How information is Ⅴ aluation using reflected in security comparables prices Valuation models The efficient markets hypothesis uesTc
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
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 uesTc
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
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 uesTc
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
Finance School of management Market value book value You buy a house for ABC Realty Balance Sheet S100.000 on january 1 January 1, 19XO 19X0 and rent it out to Assets make a profit Land 25,000 Build 75000 You finance the purchase Liabilities with $20, 000 of your own Mortagage loan 80.000 money(equity financing Ownerd Equity(Net Worth)20,000 and an $80,000 mortgage loan from a bank(debt ABC Realty market-Value Balance sheet financing) January 2, 19X0 . On January 2, someone Assets makes you a bona fide Land building $150.000 offer of s150,000, which liabilities is the market value Mortagage Loan 80000 Oner口 equity△ Net Worth) 70,000 uesTc
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. Assets Land $25,000 Building 75,000 Liabilities Mortagage Loan 80,000 Owner抯 Equity (Net Worth) 20,000 ABC Realty Balance Sheet January 1, 19X0 Assets Land & Building $150,000 Liabilities Mortagage Loan 80,000 Owner抯 Equity (Net Worth) 70,000 ABC Realty Market-Value Balance Sheet January 2, 19X0
Finance School of management Market Price fundamental value ORS 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 uesTc
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
Finance School of management Efficient Market Hypothesis (EMH) An assets current price fully reflects all publicly available information about future economic fundamentals affecting the asset's value uesTc
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
Finance School of management How Does the market pool the information pieces A typical analyst-investor 's decision making Collecting the information orfacts Determining the best estimate(expectation) P(1) 1 P(0) Determining the extent of dispersion around the estimate(risk) Risk-return trade-off, budget limitation and investment decision or recommendation uesTc
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) P(1) r = −
Finance School of management How Does the market pool the Information pieces gregation 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 ofanalysts'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. uesTc
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
Finance School of management 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 uesTc 10
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