INVESTMENT VALUATION

1. Why do we need to do valuation?

Valuation is a crucial process in finance and investment for several reasons:
1. Investment Decision-Making: Valuation helps investors and financial professionals
make informed decisions about buying, selling, or holding assets. Whether it's stocks, bonds,
real estate, or a business, knowing the true value of an asset helps in making wise investment
choices.
2. Mergers and Acquisitions: Companies use valuation to determine the value of potential
merger or acquisition targets. This is essential for negotiating deals and ensuring that
shareholders are getting a fair price.
3. Financial Reporting: Valuation is used in financial reporting to determine the fair value
of assets and liabilities, which is especially important for companies that follow International
Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP).
4. Raising Capital: When companies need to raise capital by issuing stocks or bonds, they
need to determine the fair value of these securities, which is often done through valuation.
5. Bankruptcy and Liquidation: In the unfortunate event of bankruptcy or liquidation,
valuation is used to assess the value of a company's assets and determine how the proceeds
should be distributed among creditors and shareholders.
6. Estate Planning: Valuation is important for estate planning, helping individuals and
families estimate the value of their assets for tax and inheritance purposes.
7. Legal Disputes: Valuation plays a significant role in legal disputes, such as divorce
settlements, shareholder disputes, or insurance claims, where the value of assets or damages
needs to be determined.
8. Financial Risk Management: Valuation is essential for managing financial risk. Banks
and financial institutions use it to determine the value of collateral for loans and manage the
risk associated with financial derivatives.
9. Strategic Planning: Businesses use valuation to assess their own worth and that of their
competitors, helping in strategic planning, decision-making, and setting financial goals.
10. Taxation: Governments use valuation to assess property and asset values for tax
purposes. Individuals and businesses rely on valuation to calculate taxes on real estate, capital
gains, and other taxable assets.
2. Compare equity valuation versus firm valuation and discounted cashflow valuation
Equity valuation, firm valuation, and discounted cash flow (DCF) valuation are all methods
used to determine the value of a business or an investment. Here's a comparison of these
concepts:
1. Equity Valuation:
 Focus: Equity valuation primarily values the ownership stake (equity) in a company,
which includes common and preferred shares.
 Purpose: It is used to estimate the value of a company's equity, which is relevant to
shareholders and potential investors.
 Inputs: Equity valuation considers the cash flows and earnings that are available to
equity holders after accounting for debt payments, preferred dividends, and other obligations.
 Common Methods: Common equity valuation methods include the Price/Earnings (P/E)
ratio, Price-to-Book (P/B) ratio, Dividend Discount Model (DDM), and the Gordon Growth
Model (GGM).
 Perspective: It looks at the value from the perspective of shareholders and assesses the
return they can expect.
2. Firm Valuation:
 Focus: Firm valuation determines the total value of the entire business, including both
equity and debt.
 Purpose: It is used to assess the overall value of the company, which is relevant for
various stakeholders, including shareholders, creditors, and potential buyers or acquirers.
 Inputs: Firm valuation considers the total cash flows generated by the business,
including those available to both equity and debt holders.
 Common Methods: Common firm valuation methods include Enterprise Value (EV),
Market Capitalization, and the Replacement Cost Method.
 Perspective: It provides a holistic view of the company's value, considering all forms of
capital (equity and debt).
3. Discounted Cash Flow (DCF) Valuation:
 Method: DCF valuation is a method used in both equity and firm valuation. It calculates
the present value of future cash flows generated by an investment or business.
 Focus: DCF can be used for both equity and firm valuation by adjusting the cash flows
to account for the interests of various stakeholders.
 Inputs: DCF valuation requires estimating future cash flows, selecting an appropriate
discount rate (usually the Weighted Average Cost of Capital, or WACC), and determining a
terminal value.
 Flexibility: DCF is highly flexible and can be tailored to the specific valuation context. It
can consider the interests of equity holders only or incorporate the interests of both equity and
debt holders, depending on the valuation purpose.
 Intrinsic Value: DCF aims to find the intrinsic value of an investment or business by
discounting future cash flows back to their present value.
In summary, equity valuation focuses on the value of the ownership stake in a company, firm
valuation considers the total value of the business (including debt), and DCF valuation is a
method that can be applied to both equity and firm valuation by adjusting cash flows to reflect
the interests of stakeholders. The choice between these methods depends on the valuation
context and the specific needs of stakeholders.
3. How to measure risk?
Measuring risk is a critical component of financial decision-making and portfolio management.
There are several methods and metrics to assess and quantify risk, each applicable to different
contexts. Here are some common ways to measure risk:
1. Standard Deviation:
 Standard deviation is a statistical measure that quantifies the volatility or dispersion of
returns from the mean or average return of an investment. It provides a measure of historical
risk.
 A higher standard deviation indicates greater price volatility, which is often associated
with higher risk.
2. Beta:
 Beta measures an investment's sensitivity to market movements. It compares the
investment's historical returns to the returns of a benchmark index (usually the market).
 A beta of 1 indicates that the investment tends to move in sync with the market. A beta
greater than 1 suggests higher volatility and risk, while a beta less than 1 indicates lower
volatility and risk.
3. Value at Risk (VaR):
 VaR measures the potential loss in the value of an investment or portfolio over a
specified time horizon and at a given confidence level.
 It helps investors understand the maximum loss they might incur under normal market
conditions, providing a risk threshold.
4. Capital Asset Pricing Model (CAPM):
 CAPM uses beta and the risk-free rate to estimate the expected return of an investment,
taking into account both systematic (market) and unsystematic (specific to the investment) risk.
5. Sharpe Ratio:
 The Sharpe Ratio measures the risk-adjusted return of an investment by comparing its
return to its risk (typically using standard deviation).
 A higher Sharpe Ratio indicates better risk-adjusted performance.
4. Compare these models: CAPM, APM, Multi-factor and Proxy
The Capital Asset Pricing Model (CAPM), Arbitrage Pricing Model (APM), Multi-factor
models, and Proxy models are all used in finance to understand and evaluate the risk and return
characteristics of investments. Here's a comparison of these models:
1. Capital Asset Pricing Model (CAPM):
 Focus: CAPM focuses on the relationship between the expected return of an investment
and its beta, a measure of systematic risk.
 Assumptions: CAPM assumes that investors are risk-averse, markets are efficient, there
is a risk-free rate, and that all investors have the same expectations.
 Factors: It considers only one factor, the market factor (systematic risk).
 Equation: E(Ri) = Rf + βi(E(Rm) - Rf), where E(Ri) is the expected return of the
investment, Rf is the risk-free rate, βi is the beta of the investment, and E(Rm) is the expected
return of the market.
 Applicability: CAPM is commonly used for estimating the required return on an
individual stock or an entire portfolio.
2. Arbitrage Pricing Model (APM):
 Focus: APM is a multifactor model that focuses on the relationship between the
expected return of an investment and multiple risk factors.
 Assumptions: APM does not rely on specific assumptions about investor behavior or
market efficiency.
 Factors: APM allows for multiple factors, which can include macroeconomic variables,
industry-specific factors, and others.
 Equation: E(Ri) = α + β1F1 + β2F2 + ... + βnFn, where E(Ri) is the expected return of
the investment, α is the expected return not explained by the factors, and β1, β2, ... βn are
sensitivities to each factor (F1, F2, ... Fn).
 Applicability: APM is used for pricing assets and explaining their returns based on a
range of relevant factors.
3. Multi-factor Models:
 Focus: Multi-factor models extend APM by considering various risk factors, both
systematic and unsystematic, to explain asset returns. They can include additional factors like
value, size, momentum, and liquidity.
 Assumptions: Multi-factor models do not rely on specific assumptions but incorporate
various factors to explain returns.
 Factors: These models are flexible and can include a wide range of factors beyond
market risk, including industry-specific, style-specific, or macroeconomic factors.
 Equation: Similar to APM, multi-factor models use a linear equation with sensitivities
to various factors.
 Applicability: Multi-factor models are widely used in portfolio management, asset
allocation, and asset pricing, particularly in the context of multifactor investing.
4. Proxy Models:
 Focus: Proxy models are simplified and practical approaches to estimate returns and
risks without explicitly modeling complex risk factors.
 Assumptions: Proxy models often make simplifications and assumptions to reduce the
complexity of analysis.
 Factors: They may consider only a few essential factors or proxies for risk and return,
such as historical returns, price-earnings ratios, or macroeconomic indicators.
 Equation: Proxy models use simple relationships, ratios, or historical data to estimate
returns.
 Applicability: Proxy models are used in cases where a more straightforward and less
data-intensive approach is sufficient for decision-making or analysis. They are often applied in
investment screening, performance analysis, or benchmarking.
In summary, CAPM and APM are theoretical models with different focuses and assumptions.
Multi-factor models extend APM by incorporating additional risk factors. Proxy models
provide a simplified and practical approach to estimating returns and risks, often based on
easily accessible data and simplified relationships. The choice of model depends on the
complexity of the analysis and the availability of data and expertise.
5. What are some problems with beta?
Beta is a widely used measure of an investment's systematic risk, but it is not without its
limitations and problems. Here are some of the key issues associated with beta:
1. Sensitivity to Data Periods: Beta is highly sensitive to the choice of data period used to
calculate it. Different data periods can result in significantly different beta values, which can
make it challenging to compare betas across different studies or time frames.
2. Assumes Linear Relationship: Beta assumes a linear relationship between an asset's
returns and the market returns. In reality, market dynamics can be nonlinear, especially during
extreme market conditions.
3. Assumes Constant Beta: Beta assumes that an asset's risk remains constant over time.
However, an asset's beta can change due to various factors, including changes in the company's
business risk, capital structure, or market conditions.
4. Doesn't Capture All Risk: Beta primarily measures systematic risk, which is related to
market movements. It does not capture all types of risk, such as company-specific risk
(unsystematic risk) or risks associated with events like changes in management, regulatory
changes, or technological developments.
5. Assumes Efficient Markets: Beta assumes that markets are efficient and that all
relevant information is reflected in asset prices. In reality, markets may not always be perfectly
efficient, and there can be informational inefficiencies.
6. Sensitivity to Benchmark Choice: The choice of a benchmark index for calculating
beta can impact the results. Different benchmarks can lead to variations in beta values, making
it necessary to select a relevant benchmark for the asset in question.
7. No Insight into Magnitude of Risk: Beta provides information about the direction of a
relationship between an asset and the market but does not provide insight into the magnitude of
risk. Two assets with the same beta can have different levels of risk.
8. Data Availability: Beta calculations require historical return data for the asset and the
market index. This data may not always be readily available for certain investments or may
have data gaps.
9. Inadequate for Diversified Portfolios: Beta is more useful for individual assets or
narrowly focused portfolios. For diversified portfolios, beta may not capture the full range of
risk factors, and other risk measures like value at risk (VaR) or more comprehensive risk
models may be necessary.
6. Discuss the meaning of raw beta, adjusted beta, R-squared, and standard error of
beta.
Raw Beta, Adjusted Beta, R-squared, and Standard Error of Beta are key concepts in finance,
particularly when assessing an asset's risk and relationship with the broader market. Here's an
explanation of each term:
1. Raw Beta:
 Meaning: Raw beta, also known as unadjusted beta, represents the sensitivity of an
asset's returns to market returns. It quantifies the asset's systematic risk, which is the risk
associated with market movements.
 Calculation: It is calculated by regressing the historical returns of the asset against the
historical returns of a chosen market index, such as the S&P 500. The slope of the regression
line represents the raw beta.
2. Adjusted Beta:
 Meaning: Adjusted beta is a modification of raw beta that considers additional factors to
provide a more accurate assessment of an asset's risk. It adjusts for various influences on an
asset's returns, such as a changing business risk profile or market conditions.
 Calculation: Adjusted beta can be calculated using regression analysis that incorporates
not only market returns but also other relevant factors. For example, it may include company-
specific risk factors, industry risk, or economic conditions.
3. R-squared (R²):
 Meaning: R-squared measures the goodness-of-fit of the regression model that
calculates beta. It represents the proportion of the asset's returns that can be explained by the
returns of the chosen market index. A higher R-squared indicates a better fit, implying that a
larger portion of the asset's risk is systematic.
 Range: R-squared values range from 0 to 1. An R-squared of 1 indicates that all of the
asset's returns can be explained by market returns, while an R-squared of 0 suggests that none
of the asset's returns are related to market movements.
 Interpretation: If an asset has a high R-squared with the market (close to 1), it suggests
that market movements have a significant influence on the asset's returns.
4. Standard Error of Beta:
 Meaning: The standard error of beta measures the accuracy and reliability of the
estimated beta. It quantifies the level of uncertainty associated with the calculated beta. A
lower standard error indicates a more precise estimate.
 Calculation: The standard error of beta is derived from the regression analysis. It
considers the scatter of data points around the regression line. Smaller scatter results in a lower
standard error.
 Interpretation: A low standard error implies a more reliable estimate of beta, while a
high standard error suggests a less reliable estimate. A wide range of potential beta values is
associated with a high standard error.
7. Khi nào nên sử dụng GAR và khi nào nên sử dụng AAR?
GAR (Geometric Average Return) and AAR (Arithmetic Average Return) are two methods to
calculate average returns in evaluating investment performance. How you should use each
method depends on the goals and context of the particular investment evaluation. Here's when
to use GAR and when to use AAR:
Using GAR (Geometric Average Return):
Calculating long-term investments: GAR is often preferred when you want to know the average
performance of an investment over a long-term period, such as over years or decades. This is
because GAR shows the interaction of profit ratios over time and allows you to evaluate the
total performance over that period.
Determine cumulative performance: GAR is appropriate when you want to know how a long-
term investment has accumulated returns over time. This is meaningful in determining how
investment profits are growing according to what rules.
Prefer logarithmic charts: When you use logarithmic charts to track investment returns over
time, GAR is often preferred because it shows reasonable growth on a logarithmic chart.
Using AAR (Arithmetic Average Return):
Compare daily or monthly performance: AAR is often used to compare the performance of
investments over shorter periods of time, such as daily, monthly or quarterly. This is suitable
when you want to know the average performance over a short period of time without worrying
about variation over time.
No biological rate calculation required: AAR does not require biological rate calculation, and it
is easily calculated by adding all returns and dividing by the number of observation periods.
Evaluating performance over short-term cycles: AAR is often favored when you want to
evaluate investment performance over short-term cycles, for example tracking daily or monthly
volatility in financial markets.
In short, choosing between GAR and AAR depends on your specific goals and the time horizon
you're interested in. GAR is often favored for long-term investing and the accumulation of
returns over time, while AAR is often used to evaluate performance over shorter time periods
and in short-term cycles.