Financial Valuation Flashcards
Valuation definitions;
Financial valuation
Accounting fair value
Financial valuation - Process of estimating market value of an asset, a liability, equity, or a business enterprise
Accounting fair value - Price received to sell an asset or paid to transfer a liability in an orderly transaction between market participants
Input characteristics - framework for fair value determination via US GAAP
LVL 1 - Highest LVL;
1) Inputs are unadjusted quoted prices in active markets identical to those being valued that the entity can obtain at the measurement date
2) Quoted price in an active market are the most reliable evidence of fair value and should be used when available
LVL 2 - MIDDLE;
1) Quoted prices for SIMILAR assets or liabilities in active markets
2) Quoted prices for identical or similar assets/liabilities in markets that are not active markets - few relevant transactions, prices not current or vary, or for which little information exists publicly
3) Inputs, other than quoted prices, including interest rates, yield curves, credit risks, and default rates
LVL 3 - LOWEST;
1) Unobservable
2) Should reflect the entity’s assumptions about what market participants would assume and should be a developed on the basis of best information available in circumstances
Valuation Approaches
1) Market approach - Uses prices and other relevant information generated by market transactions identical or comparable to those being valued
2) Income approach - Converts future amounts of economic benefits or sacrifices of economic benefit to determine what those future amounts are worth as of the valuation date
- Based on premise that a market participant is willing to pay the present value o the future economic benefits to acquire an item
3) Cost approach - ( MOST LIMITED) Valuation techniques used to determine the amount required to acquire or construct a substitute item (replacement cost or reproduction cost)
LVL 1 INPUTS
Active market price for item = fair value of that item
CAPM Capital Asset Pricing Model
Determines a measure of relationship between risk and specific return;
Incorporates both time value of money - using risk free rate of return and Element of risk - beta
RR = RFR + beta (ERR-RFR)
The rate paid on U.S. Treasury Bonds (2%) is considered the risk-free rate of return in the U.S
CAPM beta
Systematic risk as reflected by volatility of an investment or other asset
Measure of volatility of an asset when compared to a benchmark for the whole class of that asset;
Beta = 1, >1, 1: more volatile
A graph which plots beta would show the relationship between the return of an individual asset and the return of the entire class of that asset, as reflected in a benchmark return for the class.
CAPM assumptions and limitations
Assumes asset class and benchmark for asset being valued
All investors have equal access to all investment and class being values
Assumes asset risk is being valued solely by variance of asset being valued from asset class benchmark
No external costs involved
No restrictions on borrowing or lending @ risk free rate
Uses historical data
Option
A contract that entitles the owner (holder) to buy (call option) or sell (put option) an asset (e.g., stock) at a stated price within a specified period. Financial options are a form of derivative instrument (contract)
European vs American style option
European - Can only be exercised at the expiration date while an American can be exercised at any date prior to maturity
Valuing Options
May or may not have value, based on 6 factors:
1) Current stock price relative to exercise price of the option
2) Time to expiration of the option
3) Risk-free rate of return, high risk-free rate, the greater the option value
4) Measure of risk for security, like standard deviation
5) exercise price
6) dividend payment on option stock; less dividend = greater the option value
Black Scholes
Developed to value options under specific conditions, for:
1) European call options
2) Options for stocks that pay no dividends
3) Options for stocks whose price increases in small increments
4) Discounting the exercise price using the risk-free rate (constant)
Main thing Black Scholes also has is probability:
1) Likelihood that the price of the stock will pay off within the time to expiration
2) Likelihood that option will be exercised
Binomial Option Pricing Model (BOPM)
1) uses a “tree” to estimate value @ a number of time points between the valuation date an expiration of option
2) each time point where tree “branches” represents possible price for stock at time
3) valuation is performed working backwards through tree
4) value computed at each stage is the value of option at that point in time
- The BOPM process consists of three basic steps:
a. Generate a price tree
b. Calculate the option value at each tree end node
c. Sequentially calculate the option value at each preceding node (tree branch)
Business Valuation
Business Valuation Process 4 things;
1) Establishing standards and premise of valuation
2) Assessing economic environment of entity being valued
3) Analyzing financial statements and related information
4) Formulating value
Alternative Approaches to Business Valuation
Market approach
Income approach
Asset approach
Market approach
(Guidelines public company method)
Value of business comparing it with similar entities on market
