economic valuation concepts - actuaries institute€¢ the current use of economic valuations is...

T h e I n s t i t u t e o f A c t u a r i e s o f A u s t r a l i a A B N 6 9 0 0 0 4 2 3 6 5 6

L e v e l 7 C h a l l i s H o u s e 4 M a r t i n P l a c e

S y d n e y N S W A u s t r a l i a 2 0 0 0 T e l e p h o n e 0 2 9 2 3 3 3 4 6 6 F a c s i m i l e 0 2 9 2 3 3 3 4 4 6

E m a i l : i n s a c t @ a c t u a r i e s . a s n . a u

Economic Valuation Concepts

© 2002 The Institute of Actuaries of Australia

This paper has been prepared for issue to, and discussion by, Members of the Institute of Actuaries of Australia. The Council wishes it to be understood that opinions put forward herein are not necessarily those of the Institute and the Council is not

responsible for those opinions.

W e b s i t e : w w w . a c t u a r i e s . a s n . a u

STATEMENT OF POSITION The Institute of Actuaries Australia (IAAust) is preparing professional guidance for Actuaries who perform economic valuations. This is the first stage of providing professional guidance to actuaries in respect of a range of valuations including fair valuations and, potentially, market valuations. As part of this task, the IAAust has formed an Economic Valuations Taskforce and has conducted research on economic valuations. IAAust has prepared this position statement which deals with economic valuation concepts.

EXECUTIVE SUMMARY • The Institute of Actuaries Australia (IAAust) is preparing professional guidance for Actuaries

who perform economic valuations. As part of this process, IAAust has formed a Taskforce and conducted research on economic valuations.

• Valuations underpin a wide range of commercial decisions, including capital raising and sale of

assets. This position paper examines four distinct valuation concepts that are in wide use: Economic Value, Market Price, Market Value, Fair Value.

• Economic valuations seek to establish the value of an asset or a company by examining future

anticipated cash flows taking into account the various risks and probabilities which might be associated with achieving those cash flows. It is a core value around which market value or fair value can be constructed.

• Economic valuations are important and need to be undertaken with rigour to ensure, continued

public confidence in markets and their operation and confidence in corporate governance. • A range of advisers and professionals, including actuaries, undertake valuations. • The purpose of IAAust’s research is to develop a more rigorous and consistent basis for

undertaking economic valuations. Uses of Economic Valuations • There is a wide range of potential users of economic valuations. These include: owners,

directors and managers of the Economic Asset being valued; owners, directors and managers of another organisation interested in transacting in some way with the Economic Asset being valued; shareholders and prospective shareholders; creditors and prospective creditors; equity analysts; rating agencies; and regulators.

• Many of the users of valuations, are external to the company/business being valued, and will

have limited access to internal information concerning the Economic Asset. They require as much information as possible about the business and its future prospects from the economic valuation that is undertaken on their behalf.

Institute of Actuaries of Australia page 2

Economic Valuation Concepts Executive Summary

• The current use of Economic Valuations is wide and includes: publication in corporate financial statements; mergers and acquisitions; share purchase decisions; corporate restructuring; capital raisings; internal management (planning, investment decisions), performance measurement, risk management, capital allocation, and regulatory supervision.

• Users need to have confidence in valuations and expect them to: be technically accurate; based

on sensible methodologies that reflect real world conditions; produce robust results that are comparable; be easily understood by the users; have sufficient disclosure to determine any sources of uncertainty; and be clear on the uses that the particular valuation is suitable for.

Actuaries and Valuations • Actuaries are experts in the valuation of financial risk. As a profession, actuaries have

a particular ability to identify risks, quantify risk and place a value on risk. As a consequence, a valuation by an actuary will account, in a more robust way, for the degree of uncertainty associated with an outcome compared with those prepared by other types of valuers.

Economic Valuation Concepts • An Economic Asset is any resource, property, rights or interests that can potentially generate

future cash flows (directly or indirectly) to an individual, corporation, community or nation. Economic Assets can be thought of as having both a vertical and horizontal scope

• An Economic Value of an Economic Asset is an estimate of the current cash equivalent of all

the future cash flow benefits (or costs) that are expected to be derived from ownership or use of the Economic Asset by a specified Client in the specified circumstances. Conceptually, an Economic Value is a single number; however, the uncertainty of the estimation process often results in Economic Values being expressed as a range of possible values.

• To derive an Economic Value it is necessary to determine the expected (or expected range of)

cash flow benefits over all relevant future periods; and deflate the multiple future cash flow benefits into a current day cash equivalent (or range of equivalents).

• All forms of value are relative measures influenced by: the individual circumstances of the

specific Clients (the buyer(s), seller(s) and holder(s); and the timing and the context of the valuation.

• A Market Price of an Economic Asset is the agreed exchange rate for the Asset at a

specified time between two particular willing parties following a negotiation, based on their perceptions of the Economic Value of the Economic Asset (and possibly other non-economic factors). A Market Price can only be known with hindsight after the transaction has been concluded.



• The actual Market Price will be a result of a blend of party (buyer and seller) specific factors , information gaps and judgements on available information. As a result, the price struck in a particular transaction between these two parties may therefore not be the same as the price that would be struck between another two parties, even if all the other transaction conditions were otherwise the same. Further, a Market Price gives no insight into the Economic Values that the parties assessed for the Economic Asset other than that the seller’s Economic Value was less than or equal to the Market Price and the buyer’s greater than or equal to the Market Price.

• Observed Market Prices may differ from the actual Market Price. • A Market Value is an ex-ante quantity in that it is an estimate of a Market Price . • As it is an estimate of a specific Market Price, a Market Value is subject to the same influences

that impact on Market Price. It will include the valuer’s view of the anticipated buyers’ and sellers’ view of the Economic Asset, its operating environment, the market’s “sentiment” and the bidding/negotiation process.

• Fair Value (‘Fair Market Value’) is a valuation concept that is under ongoing debate. • Latest thinking about Fair Value appears to presume that there are no material information gaps

and that all potential Clients or parties to a transaction are homogenous. Fair Value appears to contemplate a perfectly competitive and rational market where “market sentiment” is muted, or even suppressed, leaving the rational component of trade in the Economic Asset to determine exchange prices.

• In summary, Fair Value appears to be conceptually similar to a hypothetical Market Value in a

perfect market, In fact, it appears that Fair Value is almost a link between Market Value and Economic Value. However in practice, there are some difficulties in coming to agreement on the detailed assumptions, which would support an assessment of Fair Value.



TABLE OF CONTENTS 1 INTRODUCTION.............................................................................................................6 1.1 Background....................................................................................................................................6

1.2 What do Clients/Employers Want from Valuers?..........................................................................6

1.2.1 Users of Economic Valuations.......................................................................... 6 1.2.2 Uses of Economic Valuations........................................................................... 7 1.2.3 What do Clients want from Valuers? ................................................................ 7

1.3 Actuarial involvement in Economic Valuations ............................................................................8

2 ECONOMIC VALUATION CONCEPTS..........................................................................8 2.1 Valuation concepts.........................................................................................................................8

2.2 Economic Asset .............................................................................................................................8

2.2.1 Introduction....................................................................................................... 8 2.2.2 Scope of the Economic Asset being valued ..................................................... 9

2.3 Economic Value...........................................................................................................................11

2.3.1 Introduction..................................................................................................... 11 2.3.2 Fundamental value ......................................................................................... 11 2.3.3 Party Specific Factors and Information Gaps ................................................. 12

2.4 Market Price.................................................................................................................................12

2.4.1 Definition......................................................................................................... 12 2.4.2 Relationship between Market Price and Economic Value

- The Negotiator’s Perspective ....................................................................... 13 2.4.3 Market participants ......................................................................................... 14 2.4.4 Observed Market Price................................................................................... 14 2.4.5 Summary ........................................................................................................ 15 2.4.6 Relationship Between Market Price and Economic Value

- The Valuer’s Perspective ............................................................................. 15 2.5 Market Value ...............................................................................................................................16

2.6 Fair Value ....................................................................................................................................17

2.7 Other valuation related Matters ...................................................................................................18

2.7.1 Passive Valuation Bases ................................................................................ 18 2.7.2 Limited scope valuations ................................................................................ 18 2.7.3 Transaction costs ........................................................................................... 18

ATTACHMENT 1....................................................................................................................19

1 INTRODUCTION

1.1 Background

In light of the increasing range of economic valuations actually being undertaken by actuaries, the Institute of Actuaries Australia (herein IAAust) established a Task Force to research the practice of performing economic valuations and to draft professional guidance for IAAust Members. The IAAust welcomes comment and feedback on this position statement. Written comments can be sent by e-mail to the chair of the Task Force, Mr Bruce Edwards at [email protected]. This position statement covers the economic valuation concepts presented by the Task Force and agreed by the IAAust 1.2 What do Clients/Employers Want from Valuers?

1.2.1 Users of Economic Valuations

There is a wide range of potential users of economic valuations; key users are likely to include: • The board, management and advisers of the Economic Asset being valued;

• The board, management and advisers of another Client interested in transacting in some way with the Economic Asset being valued;

• Shareholders and prospective shareholders;

• Creditors and prospective creditors;

• Equity analysts;

• Rating agencies; and

• Regulators. These users will expect to be able to understand the key aspects of the economic valuation results and their implications. Many may want to check the results for reasonableness against other valuation frameworks they are more familiar with. However, they often will only have a limited amount of time in which do so. Some users of economic valuations may not have any financial background or training. Many of the users will be external to the company/business being valued, and as such will have only limited access to information concerning the Economic Asset. They will therefore be looking to obtain as much information as possible about the business and its future prospects from the economic valuation results.



mailto:[email protected]

1.2.2 Uses of Economic Valuations

There are a wide range of uses made of Economic Values. Amongst the purposes for which economic valuations are currently used are: • Publication in financial statements;

• Mergers and acquisitions;

• Share purchase decisions;

• Corporate restructuring;

• Capital raisings;

• Internal management purposes, including:

- Business planning;

- (Dis-)investment decisions;

- Performance management and rewards;

- Capital allocation decisions;

- Risk management; and

• Regulatory purposes. The purpose of the economic valuation will typically affect the degree of rigour by which it is determined. 1.2.3 What do Clients want from Valuers?

Bearing in mind both the likely users and uses of Economic Values, it seems reasonable to assume that Clients will expect the following from actuaries determining economic valuations:

Accuracy of technical calculations; •

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Appropriate and sensible methodologies, that reflect real operating conditions as far as possible;

Robust valuations;

Comparable valuations, that is a degree of uniformity of results between practitioners;

Results that are easily understood and communicable;

Results that are reconcilable to alternative (approximate) valuation methodologies;

Sufficient disclosure to understand the sources of value;

Sufficient disclosure to understand the key features/weaknesses of the valuation including the sources and degree of uncertainty - this may include sensitivity or scenario results; and

Sufficient disclosure to understand those purposes for which the valuation may be suitable and those for which it is not.



1.3 Actuarial involvement in Economic Valuations

Actuaries are widely regarded as experts in the valuation of financial risk. As a profession actuaries have a particular ability to identify risks, quantify risk and place a value on risk. Therefore, a valuation of an uncertain outcome prepared by an actuary will usually allow in a more robust way for the degree of uncertainty surrounding the outcome than that prepared by other valuers. The actuary’s analytical ability also allows for an insightful analysis of movement in value over time and of the sources of value in terms of understandable component parts. The IAAust believes that modern actuaries should be able to offer a broad range of valuation approaches and techniques, suitable for different purposes, with the results, implications and limitations of each communicated effectively to users. 2 ECONOMIC VALUATION CONCEPTS

2.1 Valuation concepts

There appear to be four distinct valuation concepts in wide use: Economic Value Market Price Market Value Fair Value The concepts are interconnected, each dealing with the same issue at the heart of the valuation process, namely the value of an Economic Asset. These concepts of value are developed in the next few sections but firstly the notion of an Economic Asset, from which concepts of value can be framed is established. Economic Value is then considered because the IAAust believes that an understanding of this concept is fundamental to an understanding of other valuation concepts. The framed definitions, which follow, are the IAAust’s own and are not derived from any particular source. Where it is possible to adopt common terminology without misunderstanding, that terminology has been used. Throughout this section there is reference to a valuation Client. This title refers to the owner or potential owner of an Economic Asset. 2.2 Economic Asset

2.2.1 Introduction

All value assessments suppose the existence of some parcel of property, cash flows and/or other economic benefits that one party owns or has a right to utilise. This is the “Economic Asset”. Often the owner may be able to pass the benefits onto another party, a buyer. In its very broadest sense, this parcel can be almost anything that the owner possesses or has rights over.



For some Economic Assets, the ‘contents’ are standardised – they are defined in advance in some way and agreed to by all potential buyers and sellers. At an opposite extreme, some Economic Assets are entirely defined by one, or both parties to any (potential) transaction. And there is a complete spectrum between these two extremes.

Example

• Fully Paid ordinary share in BHP Billiton • June 2006 Commonwealth Government Bond

with a 4.8% coupon • Barrel of West Texas Crude Oil

Are all standardised Economic Assets that are traded between buyers and sellers almost every day of the year.

Example

In a joint venture between distributors and manufacturers in the financial services industry, the products, geographic territories, terms of trade and a myriad of other matters that precisely define the Economic Asset to be valued are hammered out in a series of detailed negotiations between the joint venture partners.

There are two essential elements of an Economic Asset: • The existence of future economic benefits (including potential benefits); and

• Control12 of those benefits.

A consistent definition is:

An Economic Asset is any resource, property, rights or interests that can potentially generate future cash flows3 (directly or indirectly) to an individual, corporation, community or nation.

The defining matters over whether an object is (or is part of) an Economic Asset are whether it generates future economic benefits to the Client and whether the Client can control4 those benefits.

2.2.2 Scope of the Economic Asset being valued

The precise composition or scope of the Economic Asset is a key fact that must be understood when considering any of the valuation concepts discussed in this paper. There are two types of scope which need to be considered: • ‘Vertical scope’ refers to the range of direct cash flows that are taken into account in the

Economic Value. The valuer must consider which flows are in the value and which are outside its scope, e.g. are synergy benefits to be included or not. Vertical scope can be thought of as successive components of the Economic Asset, each component building upon the previous components and structure “below” it to form the whole of the Economic Asset being valued (assuming that the valuation scope extends that far); and

1 Or more completely “ … control over the future economic benefits such that … able to enjoy the benefits and deny or regulate the access of others to the benefits”. 2 In the context of a valuation, control refers to the state of control or entitlement to benefits that the client has defined as being contemplated when the client stated the scope of the valuation. 3 These generated cash flows can be achieved through management, holding, disposal or any other means.



4 In the broad sense noted earlier.

• ‘Horizontal scope’ refers to the range of beneficial (or detrimental) impacts that the Economic Asset and its use might have on its operating environment. The valuer must consider the relevance to the valuation Client of the indirect impact of the use of the Economic Asset on themselves (and perhaps others) e.g. what allowance should be made for future environmental effects of a project.

Whether or not ‘higher’ components such as strategic value should be factored into an Economic Value is a matter of vertical scope to be settled with the Client. Likewise, the purpose of the valuation will also impact vertical scope appropriate for the Economic Value.

Economic Asset

Horizontal Scope

Net balance sheet position

Vertical S

cop

e

Value of existing infrastructure

Strategic options

Value of existing contracts

Operational options

Cash flows

Environmental impacts

Social impacts

Cost of use of “free goods”

In regard to horizontal scope, there may be a range of stakeholders and costs and benefits which it may be appropriate to take into account. To illustrate, consider the benefits (and costs) of a mine: • To shareholders: benefits (hopefully) make a net contribution to the business revenues;

• To up-stream industries and the nation: benefits include being a source of raw materials for finished products for the community and other industry;

• To the local community: costs may include being a contributor to environmental pollution.

There will be times when a valuer will need to clarify the horizontal scope with the Client and/or bound the horizontal scope of the assessment in order to appropriately describe the Economic Value provided. Note that clarifying the horizontal scope may not be the same as confirming who the stakeholders are, since each of the stakeholders may look at value more holistically or less so.

Economic Assets can be thought of as having both a vertical and horizontal scope. The boundaries of both need to be considered when assessing the Economic Value of an Economic Asset. Both sets of scope will typically be set by, or in consultation with, the Client.



2.3 Economic Value

2.3.1 Introduction

An Economic Value of an Economic Asset is an estimate of the current cash equivalent of all the future cash flow benefits (or costs) that are expected to be derived from ownership or use of the Economic Asset for a specified Client and in the specified circumstances.

Because the economic benefits that the ownership/use of an Economic Asset brings can only be properly measured after the period of ownership/use, an Economic Value is an estimate only. This is due to the fact that the cash flows may not be certain, the time value of money is not known with certainty and the cost of uncertainty or risk is also not definitively known. An Economic Value is an ex-ante measure because it attempts to quantify things (economic benefits) that have yet to occur. It attempts to estimate the ‘current cash equivalent’ of all future benefits accruing from ownership/use of the Economic Asset, based on the manner in which the Client intends to own/use the Economic Asset. Conceptually, an Economic Value is a single number; however, the uncertainty of the estimation process often results in Economic Values being expressed as a range of possible values. Often the use of a range of possible values more appropriately communicates the uncertainty in any values being put forward. There are two essential and generic tasks required to derive an Economic Value: (a) Determine the expected (or expected range of) cash flow benefits over all relevant future

periods; and (b) Compact or distil (generically: deflate5) the multiple future cash flow benefits into a current day

cash equivalent (or range of equivalents). It is, of course, open to the valuer to use a range of methods to perform either of these tasks and the IAAust is aware of a range of generally recognised methods. Attachment 1 very quickly surveys various valuation methods used to assess Economic Value. 2.3.2 Fundamental value

Discussion on economic valuation often explores or presumes the existence of something commonly referred to as the ‘fundamental value’ or ‘intrinsic value’ of the Economic Asset. This is the absolute or universal value of an asset that is independent of Client specific factors. The IAAust has not found any research that postulates the existence of an absolute or single fundamental value of an Economic Asset. Although writers sometimes imply that such an absolute value exists, all forms of value that the IAAust is able to define are relative measures influenced by the individual circumstances of the specific Clients (the buyer(s), seller(s) and holder(s), the timing and the context of the valuation.

The IAAust believes an Economic Asset has no absolute Economic Value, as value is always a relative concept framed in the context of a particular Client and particular circumstances.



5 In this context “deflate” or deflating refers to the process of modifying the size of the cash flows that are assumed to occur in the future to allow for the liquidity preference component in the time value of money. It should not be confused with the term “deflation” used by, for example statisticians, to allow for the tendency of the price of goods to grow over time.

It is however, appropriate to note that there may well be clustering of perceived Economic Values around one or more typical uses of an Economic Asset. So, for instance, in the valuation of vacant land, there may be a limited number of generic uses to which the land can be put and hence a range of Clients may perceive a narrow range of values clustered around the “highest and best” use to which the land could be put. 2.3.3 Party Specific Factors and Information Gaps

An Economic Value is Client specific. Both the future benefits of owning/using the Economic Asset and the current cash equivalent of those benefits will depend on a range of factors that are particular to the Client, for whom the Economic Value is being assessed. Factors where the Client may have particular views based on all the information available to them will include the operating environment (both internal and external) of the Economic Asset, the quality of the skills that will be brought to bear on the management of the Economic Asset, and the inherent quality of the Economic Asset itself. It follows then that there will frequently be a range of Economic Values ascribed to any given Economic Asset reflecting the different individual attributes of the specific Clients owning or considering ownership of that Economic Asset. Another aspect of Client specificity relates to the context and purpose of the Economic Valuation. So, for instance, a valuation of a minority interest in an Economic Asset is likely to have some different considerations to a valuation of a controlling interest in the same Economic Asset. Similarly, a valuation of a business-as-is may have some different considerations to a valuation done in the context of a sale or purchase of the same Economic Asset. The blend of party specific factors and the extent of information gaps is not uniform: • Amongst Economic Assets in ‘the market’;

• For a given Economic Asset between all its potential buyers and sellers; nor

• For a given Economic Asset over time. The range and weighting of party specific factors and information gaps has a bearing on any assessment of value. 2.4 Market Price

2.4.1 Definition

A Market Price of an Economic Asset is the agreed exchange rate for the Economic Asset at a specified time between two particular willing parties following a negotiation, based on their perceptions of the Economic Value of the Economic Asset (and possibly other non-economic factors).

Two parties can be willing negotiators and subsequent transactors even where there is asymmetry of information and / or bargaining power between them.



A Market Price is an ex-post quantity that records the historical fact of the ‘actual exchange rate’ that emerged through some form of bidding or negotiation process. That price may or may not be public (i.e. observed); indeed the precise composition of the Economic Asset may not be generally known. Because the actual Market Price will be a result of a blend of party (buyer and seller) specific factors and information gaps, the price struck between these two parties may therefore not be the same as the price that would be struck between another two parties, even if all the other transaction conditions were otherwise the same. 2.4.2 Relationship between Market Price and Economic Value - The Negotiator’s Perspective

‘Price is what you pay; value is what you get’ - Warren Buffet.

The definition of Market Price the IAAust has formulated is built upon the concept of Economic Value. The price negotiation process itself could be represented as follows (Robinson 1999):

Seller’s assessmentof economic value

Buyer’s assessmentof economic value

Potential price range for negotiation- single buyer and single seller.

Prices acceptableto buyer.

Prices acceptable toseller.

The only relationship between an Economic Value and Market Price at a point in time is that illustrated above, i.e. Economic Value(buyer) >= Market Price >= Economic Value(seller). This assumes buyers and sellers are “willing but not anxious”. In a market where this is not the case, then even these relationships may break down. While for a given transaction, it might be tempting to say that the Market Price is an estimate of the Economic Value for the buyer and seller, there is no way to know how good an estimate it is for each party6. Market Price simply tells us (at best) that the Buyer’s Economic Value was greater than the Market Price and the seller’s less than the Market Price. By how much remains unresolved. Therefore Market Price is not a consensus view of Economic Value but an agreement between buyer and seller of how much of their perceptions of Economic Value they were each prepared to trade-off. 6 In general, the buyer will not know the seller’s Economic Value and vice versa. It may be possible though for the buyer and seller to estimate the other party‘s Economic Value by making ambit claims that discern at what point they are prepared to negotiate seriously.



For parties external to the transaction, it is not possible to discern any further information from the Market Price alone as to the Economic Value that each party has assessed for the Economic Asset. Stated another way:

The fact that a trade takes place does not, of itself, bound the range of Economic Values that the parties to the transaction may have assessed for the Economic Asset traded.

2.4.3 Market participants

The outline of the Market Price setting mechanism above applies to what might be termed “fundamental investors”. These are investors operating in the market using some form of fundamental economic value analysis to guide their market decisions. Markets also potentially have a range of other participants active at one time or another. Traders participate in many markets, particularly in deep markets. Traders are willing to be either a buyer or a seller according to prevailing prices and market sentiment. Traders’ perception of Economic Value may be confined to the price at which they think another party might be persuaded to complete a deal with them. At certain times and in certain markets there is another group of participants who might be called price insensitive buyers. So, for example, there can be a weight of superannuation fund money destined for a specific sector (eg international equities), a specific geography (eg USA) and even certain stocks (eg blue chip technology stocks) regardless of the current prices of the target markets or stocks. The balance of the various market participants will affect the distribution of prices within the market. Indeed it is the wide range of bases on which the different market participants formulate their own willingness to buy / sell that can lead to greater elements of sentiment in some markets than in others or in a particular market at a particular time. 2.4.4 Observed Market Price

So far, the discussion of Market Prices has assumed there is no “clouding” of the market’s ability to observe transaction prices. In practice, “observed” market prices may differ from the actual transaction price. There are two possible elements to this difference. The first is that the market may not be fully informed of all the relevant terms and conditions of the transaction, i.e. the true definition of the Economic Asset traded. The second is that the transacting parties may not release to the market full details of the cash or equivalent that changed hands. In looking to the information available from any reference market, the extent and impact of this “clouding” of the underlying transaction price must always be considered.



2.4.5 Summary

In setting Market Prices of Economic Assets: • It is not a requirement that the buyer and seller both operate with the same information;

• It will almost always be the case that the buyer and seller will place different interpretations on the information they do have;

• The Market Price that emerges will represent a trade off between the Economic Value each has determined for the Economic Asset, taking into account other factors peculiar to the buyer and seller;

• The Market Price alone tells external parties nothing more about the Economic Values that each of the two parties assessed - there is no fixed relationship between Market Prices and Economic Values; and

• The observed Market Price may differ from the actual Market Price paid as the full terms and conditions of the transaction may not be known to the market.

2.4.6 Relationship Between Market Price and Economic Value – The Valuer’s Perspective

The IAAust believes it is not possible to derive an Economic Value without linking it somehow to an observable reference market where similar Economic Assets are exchanged. That is, one must observe Market Prices in a suitable reference market7 and their behaviour in order to make inferences about parameters that enable Economic Values to be derived. This linkage does not contradict the conclusion in 2.4.2 that there is no fixed relationship between Market Price and Economic Valuation. Rather it emphasises that economic valuations should not be conducted in a vacuum but instead should be related to the (market) environment surrounding the Economic Asset. This linkage is illustrated in the diagram (below).

Economic Asset

Other Market Prices

The Market

ActualMarket Price

ObservedMarket Price

EconomicValue

ObservedMarket

Characteristics•Cost of risk•Cost of money•Cost of time•Asset differences•Client specifics•Information gaps•Other

ScreenedMarket

Characteristics•Cost of risk•Cost of money•Cost of time

Under certain circumstances, Market Prices (and also Market Values) may act as a reference point for reasonableness checking (or be used to calibrate) an Economic Value, and vice versa.



7 It may be necessary to consider alternative market(s) as proxies if the idealised reference market is neither deep nor liquid enough or else believed to be insufficiently correlated to the Economic Asset being valued.

This will depend upon the degree to which market consistency is believed to be necessary and the extent to which the party specific factors relevant to the assessment of an Economic Value are congruent with those involved when the Market Prices were set. The IAAust believes it is necessary to have strong regard to ‘the market’ which is the exchange house for Economic Assets in setting a discount rate or pay-off probabilities. For example, while an Economic Value for an Economic Asset is Client specific, should bond yields generally increase, one would expect that all Clients’ Economic Values for the Economic Asset would fall. The IAAust also believes that there is no useful distinction to be made in the valuation process between economic valuations performed for purposes of assessing holding values and economic valuations performed in the context of a potential transaction. The IAAust recognises that an economic valuation performed for purposes of assessing holding value may well have a different scope to an economic valuation performed in the context of a potential transaction. 2.5 Market Value

A Market Value is an ex-ante quantity in that it is an estimate of a Market Price that has not yet been set: a Market Price can only be known with hindsight. The estimate is of the Market Price for the Economic Asset if it were bought/sold at a point of time (being the date of the valuation) as a result of an anticipated bidding or negotiation process. Because it is an estimate of a specific Market Price, a Market Value is subject to the same influences on Market Price. It will be subject to a blend of Client specific factors and possibly information gaps that pertain to the specific transaction details noted above. In particular, it will include the valuer’s view of the anticipated buyers’ and sellers’ view of the Economic Asset, its operating environment, the market’s “sentiment” and the bidding/negotiation process. Because they are estimates of a specific Market Price (and hence subject to the variability of the conditions which determine the price; the Economic Asset, the buyer and the seller), Market Values can be formulated in a wide range of situations.

A Market Value of an Economic Asset is an estimate of a potential Market Price:

• For a specific seller or range of sellers of the Economic Asset;

• For a specific buyer or range of buyers of the Economic Asset;

• At a specific time; and

• With a set of specific market conditions pertaining at the specific time.

The IAAust notes that in certain circumstances and for certain purposes, “Market Value” may be a specific quantity defined in legislation or regulation. It is possible that where such quantities are defined, the definitions can be short and possibly non-comprehensive. The following diagram shows, in a stylised form, how a deep market consists of a range of buyers and sellers, each assessing their own Economic Value for the Economic Asset. By resolving all the possible trades that could occur at any time, the market sets a clearing price, which may be used as the Market Value at that point.



Resolve all possible trades

Emerging market value / Clearing Price

Value

Seller #nBuyer #r

Individuals’ (ie situation specific)

Economic Values

Number ofbuyers or

sellersassessingthis value

An Economic Value is not, of itself, a Market Value. However, in some contexts, an Economic Value may be a suitable proxy or estimate for a Market Value or the starting point for making an estimate of Market Value. This is particularly so where appropriate care has been taken in determining the Economic Value so as to maintain consistency with observed Market Prices. 2.6 Fair Value

Fair Value (aka ‘Fair Market Value’) is a valuation concept that is currently under considerable debate. Latest thinking about Fair Value appears to presume that there are no material information gaps and that the universe of potential Clients or transaction parties is homogenous, that is, they have party specific factors that are largely the same. On this basis, Fair Value appears to be conceptually similar to a hypothetical Market Value in a perfect market. In fact, it appears that Fair Value is almost a link between Market Value and Economic Value: • Fair Value appears to contemplate a specific Client who is representative of all the potential

Clients active in a market. It appears to contemplate a scope that sets the Economic Asset in a “stand alone” context, unaffected by influences external to the Economic Asset itself such as synergies a particular owner might bring to its ownership; and

• Fair Value appears to contemplate a perfectly competitive and rational market where “market sentiment” is muted, or even suppressed, leaving the rational component of trade in the Economic Asset to determine exchange prices.

In practice, there appears to be some difficulty in coming to agreement on the detailed assumptions which would support an assessment of Fair Value based on the assumptions outlined above. This is a part of the continuing debate about the definition of Fair Value. Several observations that can be made about Fair Value, which the IAAust believe are relevant to those involved in the debate surrounding Fair Value are:



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Institute of Actua

• Fair Value is an ex-ante estimate in that it is an estimate of a Market Price or a range of market prices that might be realised under a particular set of market conditions;

• Fair Value is Economic Asset/Liability specific. The more stylised and pre-defined the Economic Asset/Liability being valued, the fewer issues there are likely to be in determining a Fair Value, and vice versa; and

• Unlike the other three valuation concepts (Economic Value, Market Price, Market Value), Fair Value appears to contemplate either the full universe of potential buyers and sellers, or a proxy buyer and seller that are somehow representative of the full universe of potential buyers and sellers.

The IAAust considers a market consistent valuation to be a specific form of an economic valuation (where certain assumptions are set with reference to observed market parameters). 2.7 Other valuation related Matters

2.7.1 Passive Valuation Bases

It may appear from the conclusion at the end of 2.4.6, that the IAAust is advocating only active8 valuation bases. In general, the IAAust believes that active valuation bases are appropriate for Economic Valuations. However, the IAAust recognises that there may be circumstances when a passive valuation basis is appropriate. The IAAust also recognises that Clients may choose to specify passive valuation bases or some elements thereof. This is perfectly legitimate providing the reporting valuer makes clear the limitations placed on the scope of the work performed. 2.7.2 Limited scope valuations

The IAAust is aware of many circumstances when Clients request limited scope valuations, maybe better known as “back of the envelope” valuations. The IAAust recognises that the exercise of many of the tasks a valuer would ordinarily perform in a detailed valuation will be curtailed, and possibly severely curtailed, in a limited scope valuation. This is appropriate where the Client has requested it and the valuing actuary appropriately reports the character of the valuation performed and the implication for the results. 2.7.3 Transaction costs

Transaction costs can be a material part of the costs and benefits of acquiring or disposing of an Economic Asset and need to be allowed for appropriately. It is the IAAust’s understanding of commercial practice in the financial services industry that transaction costs are generally allowed for as a separate adjustment to Economic Values calculated without allowance for transaction costs. Any utilisation of Market Prices for purposes of making a link to an Economic Value (see 2.4.6) must have regard to the impact of transaction costs and what is discernible regarding them in the observable market.

8 An active valuation basis is one where each of the elements of the assumption set is actively re-calibrated to market or recent experience. By contrast, a passive valuation basis is one where the various elements of the assumption set are only revised periodically with a number of valuations over time being prepared based on the unchanged assumption set.

Attachment 1

ATTACHMENT 1

Economic Valuation Methods This attachment very quickly surveys various valuation methods used to assess Economic Value. It does not claim to be exhaustive. It is not intended to provide, ‘chapter and verse’ on each method, but rather to give a brief synopsis of each method’s key features. The diagram below is IAAust’s attempt to illustrate some of the relationships between the various methods.

Asset Replication

Appraisal values

Embedded values

Expected cash flows Decision TreeAnalysis (DTA)

Risk Adjusted Discount Rate +real probabilities

Explicit assumptions

PE ratiosEarnings Multiples

Volume ratios

Implicit assumptions

Risk-adjusted world(real world)

Financial options usingBlack-Scholes etc

Real options usingadjusted DTA

risk-free rate +risk-neutral probablities

Risk-neutral world(financial economics)

DiscountedCashFlow

State Price Deflators

Valuation Methods

Deterministic or stochastic Static or dynamic

Sensitivity testing Scenario testing Monte Carlo simulation

State price deflators (SPD). A generalised theory for converting a set of cash flows into a current cash equivalent. The so-called ‘deflators’ are derived by first establishing a series of ‘state prices’ of replicating market assets. The deflators can be decomposed into a vector of discount rates and probabilities defined in any way one likes according to the circumstances of the valuation problem. Asset Replication. Cash flows in future periods are estimated and then grouped into batches that are identical to those of one or more replicating assets. The current cash equivalent of the cash flows is assessed as the current value of the replicating assets. Discounted cash flows. Cash flows in future periods are estimated and a current cash equivalent calculated by applying time- and risk-based discounting to those cash flows.



Attachment 1

Risk-Adjusted or Risk-Neutral. It has been shown in various actuarial literature and in different ways that the ‘risk-adjusted world’ and the ‘risk-neutral world’ should (if assumptions are derived consistently) produce the same result. The risk-adjusted and risk-neutral worlds are actually techniques for applying the SPD in practice. Financial economists typically approach problems from a risk-neutral framework since they argue that all financial problems can be framed as contingent claims or options. In discounted cash flow analyses, the cash flow probabilities and the discount rate are directly related and therefore need to be consistent: • In the actuarial or risk-adjusted world – real world probabilities require a risk-adjusted discount

rate (or even multiple rates)

• In the financial economist or risk-neutral world – risk-neutral probabilities require a risk-free discount rate.

The technique which should be chosen is the one which most effectively solves the problem. For example, the only practical way of solving options valuations is via the risk-neutral approach although the risk-adjusted approach could in theory be used. The risk neutral approach, while not amendable to easy application in the areas that actuaries are familiar with, is essential in some circumstances e.g. in the area of contingent claims analysis (financial options and real options). Explicit and Implicit Assumptions. Actuaries typically prefer to make explicit assumptions. Market analysts and merchant bankers often favour methods which make implicit assumptions. Earnings multiples/PE Ratios. A normalised earnings figure is calculated and a current cash equivalent of the future stream of earnings is calculated by applying a multiple to the normalised earnings. Volume ratios. A stock of some business quantity is assayed (e.g. the funds under management for a wealth management business) and a current cash value of this quantity as it grows over time is calculated by applying a ratio to the business quantity. Decision Tree Analysis (DTA). The outworkings of a business process are tracked through all possible paths. The current cash equivalent of each path is calculated by applying time-based discounting. The current cash equivalent of the Economic Asset is calculated as a weighted average of all the paths’ results, the weights being the expected probabilities of each path. Real options. This method is an extension of DTA by overlaying a risk-neutral methodology. This is meant to adjust for the asymmetrical and time-dependent nature of the risks involved which is not properly accounted for by traditional DTA. Monte-Carlo simulations. Can be applied to any of the methods. The outworkings of a business process are repeatedly modelled with one or more random variables in operation. The current cash equivalent of each model run is calculated by applying time-based discounting. The current cash equivalent of the Economic Asset is calculated as a weighted average of all the model runs. Particularly useful when the distributions of the stochastic variables are complex or interdependent. Sensitivity/scenario testing. Ways to evaluate the impact on valuations of differing assumptions or combinations of assumptions. Helps to understand the key drivers of value.



Attachment 1



Static/dynamic; deterministic/stochastic Valuations can generally be classified as: • static or dynamic depending on the degree to which assumptions are modified or management

decisions modelled in response to the evolving projection (eg real options); and

• deterministic or stochastic depending on whether simple expected values are derived or multiple scenarios are simulated using random number generators (eg asset-liability modelling).

economic valuation concepts - actuaries institute€¢ the current use of economic valuations is...

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