Valuation of asset classes and portfolios (Formulae equating expected and…
Valuation of asset classes and portfolios
If the required return is less than the expected return, the asset seems cheap.
Formulae equating expected and required returns
GRY= rf + E(inflation) + IRP
GRY= rf + E(inflation) +CBRP
d + g= rf + E(inflation) + ERP
ry + rg = rf + E(inflation) + PRP
GRY = gross redemption yield
rf = risk-free real rate of return
E(inflation)= expected rate of inflation
IRP = inflation risk premium
CBRP = corporate bond risk premium (includes IRP)
PRP = property risk premium
d= dividend yield
g= expected (nominal) dividend growth
ry= rental yield
rg = expected (nominal) rental growth
Equity risk premium
A yield margin over and above government bond yields that is needed to compensate the investor for:
uncertainty of dividend income
d - GRY = ERP - IRP - g
reverse yield gap
GRY -d = IRP- ERP + g
reasons for a higher than normal reverse yield gap (if fairly priced)
perceptions of inflation risk have increased
perceptions of the riskiness of equities have reduced
expectations for real dividend growth have increased
expectations for inflation have increased
if not fairly priced
gov bonds may be cheap relative to equities
When an overseas market seems cheap
Expected return in local currency + expected depreciation of home currency > expected return in home currency.
Other methods used for establishing cheapness or dearness of assets
Index levels and price charts (technical analysis)
Yield ratios (used for equities and bonds)
Methods of valuing assets and liabs consistently
Both A and L using discounted cashflow approach. Interest rate represents long-term return on the assets.
Value A using market value. MV for liabs difficult so determine market-related discount rate for liabs and value using discounted cashflow approach. DR taken as the return on a portfolio of assets that most closely replicate the liabilities.
In both cases, a decision has to be made as to whether the DR should vary by asset type/liability or by term of each asset/liability cashflow.
Reasons for a volatile asset valuation
A change in the composition of the portfolio e.g. due to a tactical switch in investment policy.
Is volatility a problem?
Volatility reflects reality
Inconsistency with liability value if the latter is calculated using a stable, long-term discounted cashflow method
However, an unstable asset value is hard to communicate.
Valuing liabilities on a consistent "market-related" basis is hard to achieve (i.e. the discount rate is hard to determine)