As a financial adviser, I often notice that that there is a disconnect in clients’ minds about what they are actually buying when they purchase financial assets, such as shares and bonds. Therefore, I think an explanation of how these assets are valued might assist you in becoming more comfortable with financial assets.

Of course, I don’t propose to provide a finance lecture on the topic, because it takes many years to understand how different valuation models actually work. However, for those of you who are keen to learn a bit more about how assets are valued, then read on.

I will start off by saying that most Australian investors seem to be quite comfortable with real estate assets, but my hope is that by the time you finish reading this you will see that, quite often, the valuation of financial assets (particularly bonds) is a much more logical process than simply what the next person decides to pay. Hopefully you will also see that by using these same concepts, we can also determine when an asset is over or under value.

There are many different ways to value assets but one commonly used approach for valuing assets is the discounted cash flow (DCF) method. This method involves estimating the future cash flows generated by the asset and discounting those cash flows back to their present value using a discount rate (a percentage rate) which reflects the time value of money and the risk associated with the asset in question. The resulting present value represents the estimated value of the asset.

For example, let's say you want to value a share. You could estimate the future cash flows that the company is expected to generate over the coming years and then discount those cash flows back to their present value using a discount rate that reflects the risk associated with the stock.

Similarly, you can also use the DCF method to value real estate, by estimating the future cash flows the property is expected to generate and discounting those cash flows back to their present value using a discount rate that reflects the time value of money and the risk associated with the property. However, this is usually used by more sophisticated investors relating to commercial deals – seldom would you see Joe Citizen doing this in at the residential auction down the street.

If you’re still reading, then I suspect you might be interested in an example of how the DCF model actually works.

A bond is the simplest financial asset to understand, therefore I provide a basic example of the DCF model below using a bond as the asset in question.

Suppose you own a bond with the following characteristics:

Face value of the bond: $1,000

Coupon rate: 5% (this is the interest payment per annum as a percentage of the face value. In this case you would receive $50 p.a)

Maturity: 5 years (i.e: the bond will mature in 5 years and pay you back the face value of $1,000 at that time)

Now, lets say that interest rates suddenly rose to 6% the day after you bought the bond – what would this do to the value of your bond?

It probably goes without saying, but in this case no one would want to buy your bond for $1,000 because they now expect a return of 6%, and if they buy your bond for $1,000, with a coupon rate of 5% p.a, well…. I think you understand that 5% is less than 6% - Only a very bad investor would accept that deal!

So, how do we know what the bond you've found above is now worth? This is where the DCF (discounted cashflow) model comes in.

Remember, the DCF model allows us to calculate the present value (today's value) of an assets future cash flows.

In this case we know the following for sure:

• The future cashflow is $50 per annum
• Other investors now expect a 6% return
• The owner of the bond will receive the face value of $1,000 at maturity in 5 years’ time.

We now have the information we need to value the bond.

To determine the present value of each coupon payment, we discount it back to its present value. In this example, we discount the $50 coupon payment for each year using a 6% discount rate (i.e: the interest rate investors now expect).

Therefore, the present value of each coupon payment is:

Year 1: $50 / (1 + 6%)^1 = $47.17

Year 2: $50 / (1 + 6%)^2 = $44.48

Year 3: $50 / (1 + 6%)^3 = $41.98

Year 4: $50 / (1 + 6%)^4 = $39.64

Year 5: $50 / (1 + 6%)^5 = $37.45

You will note that each year up to year 5 is worth less and less. This makes sense, and serves to demonstrate the time value of money assuming a discount rate of 6%.

Similar to the coupon payments, we now discount the face value of $1,000 received at maturity back to its present value. Using the same 6% discount rate, the present value of the face value would be:

Face value: $1,000 / (1 + 6%)^5 = $747.26

Now that we have the present value of both the coupon payments and the face vale, we simply sum up the present values of both. In this example, it would be:

Total present value = $47.17 + $44.48 + $41.98 + $39.64 + $37.45 + $747.26 = $958.98
Therefore, based on this scenario, the estimated value of the bond is now approximately $958.98. Again, this is because the bond you found has a coupon rate of 5%, whereas the market now expects a higher rate of 6%.

In conclusion, the valuation method outlined above can be applied to other assets using similar principles and methods. The key is to estimate an asset's future cash flows and discount those cash flows back to their present value using an appropriate discount rate that reflects the time value of money and the risk associated with the asset.

Until next time, happy retirement planning!

Wayne