Investment Pricing Methods

Accounting guidelines are evolving in response to the growth and complexity ofinvestments. As a result, fair value concepts are becoming part of measurement and disclosure accounting guidelines, and, therefore, accountants must understand the fundamentals of investment pricing methods. This book was written to provide accountants with a practical understanding of how investment analysts price common financial investment instruments, such as commercial mortgages, private placement bonds, mortgage-backed securities, private and public equities, derivatives, and joint ventures. As a part of understanding investment pricing, one will need to become familiar with investment terminology that may, at times, seem confusing or have different meanings depending on one's frame of reference. For example, initially we used the word "valuation" rather than "pricing" in the title of this book. However, in discussing this topic with analysts, we were told that some investment analysts view investment valuation as a process of comparing one investment with another to determine the best relative buy, while pricing means determining an investment's current or fair market value. We therefore use the term "pricing" to avoid confusion.

To reinforce pricing concepts, we illustrate certain public security pricings, since these are often less complex than private investments. We then apply those concepts to pricing private investments. Our goal is to familiarize readers with those pricing concepts so that they will understand how investors are compensated for assuming risks and how this impacts pricing. Readers then will be able to understand the inputs used in the appropriate investment pricing model (including the basic valuation formulas), how changing market conditions impact fair values, and why certain internal control processes are important in arriving at reasonably accurate and consistent estimates of prices for private investments. We also would like readers to appreciate the limitations of such pricing procedures.

This book also introduces certain derivative hedging transactions that may be useful to accountants who are involved in reviewing similar types of transactions. Those types of transactions have become pervasive, and derivative pricing may be better understood when hedging concepts are also explained.

After reading this book, one should have a sound understanding of the foundations of investment pricing procedures and be able to apply these building blocks to evaluate the reasonableness of investment pricing calculations observed in practice. One also should be well positioned to explore more in-depth material, such as that presented in the recommended references included in this book.

Accountants and other business practitioners should have a basic understanding of the following concepts that are typically used in investment pricing procedures.

Fixed-Income Instruments

• Term structure of interest rates
• Inverse relationship between interest rates and prices of fixed-income investments
• Pricing fixed-income investments using yield curves specific to the investment type
• Composition of fixed-income yields into the risk-free rate, sector risk premium, credit risk premium, and other costs
• Credit rating categories and a process for determining such ratings
• Duration as a measure of the sensitivity of financial instruments to interest rate changes
• Convexity as a measure of the rate of change of duration and its relationship to prepayment features and call provisions
• Make-whole provision formulas and the impact of changes in interest rates
• Structures of mortgage-backed securities and asset-backed securities
• Types of loan covenant provisions and their importance in protecting value
• Common terms included in mortgage and note contracts
• Common fixed-income derivative types used for hedging instruments
• Pricing concepts and models for various fixed-income derivatives

Equity Instruments

• Common pricing methods such as price multiples and discounted-cash flow models
• Measuring risk and factoring it into the pricing model
• Components of free-cash flow in business pricing
• Impact of earnings growth rates on equity pricing
• Impact of changing discount rates on equity pricing
• Importance of covenant provisions to protect private equity investors
• Impact of control premiums or discounts in pricing private equities
• Pricing concepts and models for equity derivatives

This book begins with a discussion of the term "structure of interest rates," which is provided for those who may require a review of those fundamental concepts. Readers already familiar with those concepts may begin with Chapter 2.

Note that the FASB has issued Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements. Concepts Statement 7 outlines the framework for using present values of future cash flows in accounting measurements. In paragraph 25, the Board describes the objective of present value in the following terms: "The only objective of present value, when used in accounting measurements at initial recognition and fresh-start measurements, is to estimate fair value. Stated differently, present value should attempt to capture the elements that taken together would comprise a market price if one existed, that is, fair value."

As the name implies, a Concepts Statement addresses broad principles rather than specific techniques. However, there is no conflict between the conceptual discussion in the Concepts Statement and the pricing methodologies and concepts presented in this book.

In paragraph 23, the Board describes the five elements necessary to fully describe economic differences between various assets or liabilities:

This book is devoted to describing tools that investment professionals use to assess those elements.

A CD-ROM PowerPoint ^TM presentation is available to assist those who wish to teach this material.

Contents

• Pricing Concepts and the Term Structure of Interest Rates.
• Fixed-Income Pricing Matrix and Decomposing Yields.
• Public Corporate Bonds, Private-Placement Bonds, and Whole Commercial Mortgages.
• Mortgage-Backed and Asset-Backed Securities.
• Privately Held Equity.
• Public Equity Pricing.
• Derivatives.
• Partnerships.
• References.