Uncertainty in Valuations Can It and Should It Be Eliminated - Coursework Example

Uncertainty in Valuations – Can It And Should It Be Eliminated? Contents Definition and explanation of “uncertainty” 2 Impact of uncertainty on the market: 7 Measures taken to Deal with Uncertainty 8 Effectiveness of Measures: 10 Further Possible Measures 11 References 15 Definition and explanation of “uncertainty” The plus root theory differentiates between the meanings of truth and certainty. Degrees of certainty are important in elementary theory. Certainty can be defined as cognitive property of beliefs. It is almost impossible to provide a rigid analysis of certainty. The hardness in capturing the full value of certainty and the conflating kinds of certainty stands out to be the reasons. (Standard encyclopedia of philosophy, 2008). The factors that may have an effect on the degree of certainty includes status of the valuer, uncertainty inherent with certainty, instability in the market and restricted information access. Uncertainty can be defined as lack of certainty in a certain state where there are constraints to define the exact nature of the existing state or the future of an outcome. Frank Knight in his seminal work named “Risk, Uncertainty and Profit’ described uncertainty as distinct from risk. It is difficult for the valuer to form an independent opinion on a particular aspect because of inherent uncertainty. Even when all property valuation is uncertain yet they are represented to the client as a single point estimation keeping the context of uncertainty outside the domain. The level of market activity is responsible for the variation in degree of uncertainties. Economists have generally agreed that lack of knowledge and presence of imperfect information about the inputs used in the process of valuation can cause uncertainty. The outcome can be certain if the estimators are able to forecast the future properly. Uncertainty impacts the process of valuation in mainly two ways: The flow of cash from different investment projects are uncertain and have varying degrees and the resultant is exposed to uncertainty. (French and Gabreilli, 1994, pp.1-2) If there is need to find out whether a result is compliance or noncompliance, measurement uncertainty has to be taken into account. The uncertainty in measurement provides some information regarding quality. Knightian uncertainty Value uncertainty arises there is uncertainty in the subjective utility that a good provides prior to the completion of transaction. (Nielson, Mckee, and Berrens, 2002, pp. 11-12) The fundamental principles determine the asset values and the premise of valuation provides the opportunity to determine the estimates of the value. The method or process of determining the value of assets varies between assets and the associated uncertainty plays its role in the valuation process but the core principle remains the same for all types of assets. In order to price particular types of investment various methodologies are used and one of the vital parts of the investment process is valuation. The basis of calculation of worth in the investment process is valuation. Valuation is used by lenders when they draft loans and agreement terms. Variation in the valuation of the degree of uncertainty arises on whether these valuations are undertaken internally or externally. The future investment performance can get affected by the accuracy of valuations and it is fundamental to both to the decision making process of both from the investor’s and lender’s point of view. The valuation used in the pricing process can be regarded as uncertainty in its own right. The International Valuation Standards Board has identified the major sources that might lead to valuation uncertainty. Status of valuer: Material uncertainty is expected to arise when more reliability is put on to estimate the valuation. The level of accuracy or how close the value of the estimation will be to the observed value depends on the ability and skill of the estimator. The confidence with which the estimation can be used for further analysis depends on whether the estimation has been processed from an independent situation or the estimation is unbiased. Material uncertainty can arise if the above requirements are not met. Scope of work: The uncertainty attached to this part of valuation will depend much on nature of the valuation process and subsequent investigation taken before the assignment. The date of the valuation is taken into account. If the date is in recent past then there is a possibility that the estimation will be more certain that the estimation that was made on the date of reporting or as of a future date because the validity of inputs can act as a constraint in this cases. The investigation process can also have an impact as full and detailed investigation will provide a more certain estimate than the one which has been undertaken under certain assumptions. Verification of inputs is also important as its validity can have its shadows on the estimation. A case where compromise has been done in the investigation process as the case in the valuation of a particular asset it is expected that it will lead to material uncertainty. The verification of inputs to a valuation is of prime importance. Some of the measures to validate the inputs can be the source of the inputs. If the input is taken from any authorised source or any unauthorised source. If the inputs are taken from unauthorised sources then the value of the inputs may vary as it is not known the certain parameters under which the sources have launched such input results. It is also important to examine whether the input results are collated from a primary or secondary source. If the resultants are taken from secondary source then the source from where they collated the researches will have to be accounted. Market uncertainty: Unforeseen events like financial, macroeconomic or political crisis can cause disruption or turbulence in the market which give rise to market uncertainty. There can be a spill over effect because of panic buying or selling in the market. This may also act as disincentive to trade until the long term benefits are recognised in the market. Stress on the market points to inconsistency of data or even contradiction in data causing uncertainty to take effect. Microeconomic events can also be held responsible for market uncertainty. A sudden restriction imposed by law may result in suspension of activity of a particular type of asset or may give rise to speculative activity. Model uncertainty: The method of valuation and characteristics of the model to be evaluated is the reason for model uncertainty. For certain type of assts a particular method is used to customarily deduce the value of the estimator. But in many cases that particular method may not be the appropriate one and it may give rise to the source of uncertainty as they will not produce the same outcome. Therefore the selection of the appropriate method is of prime importance. Again in certain valuation models the outcome may be sensitive to small changes in the inputs and variation in the estimation may be huge which will lead the entire estimation process in vain. The gearing effects of the model can be treated as the reason to give rise to model uncertainty. Input uncertainty: This type of uncertainty arises from the degree of veracity that is associated with the inputs in the data that has been used for valuation and they have their effect on the outcome. Suppose the source of input is consensus data there is usually a range between which the market value can fluctuate. When the input is taken from a historical data there is need for some assumptions to adjust the data according to the date of valuation which can be a source of uncertainty. Even in cases where inputs are estimated from the observable prices, the adjustment can result in uncertainty. However the above mentioned causes are not mutually exclusive. A link often exists between the fourth and last cause of uncertainty as different inputs may be exposed to different levels of uncertainty. The market, input and uncertainties arising from model can have simultaneous effect on an asset. The factors of uncertainty are therefore interdependent and correlated. So it must be taken into account during the valuation process. The models of valuation which are subjected to small changes in the inputs are Valuation using Gordon Growth Model, Discounted cash flow Analysis, Black-Scholes model and Dividend Discount Models. In valuation models, multiples are derived from comparing the companies that are publicly traded. The comparison between the pricing results for a private firm with an observable market price can act to assess the accuracy of the multiples. The market capitalisation can be used for this purpose firms that are similar publicly traded. Selecting a range of values rather than a discrete one can provide a proper methodology to establish the valuation of the potential firm. The differences in land value can be regarded as an example of the difference of property value. Suppose two similar lands exist on adjoining plots. Both plots are of the same size but the one of the plots has a market value of 50,000 dollars for 1.5 acre and the other has 125,000 dollars for 5 acres. If valuation is based on the size of the plot then both would have the same valuation. A value of a particular house may go up due to capital gains or due to developments that was desirable in its vicinity or due to proximity to other properties that are valuable. Impact of uncertainty on the market: A market is defined as a place where buyers meet sellers. In corporate takeovers targets must be set to sell the firm in optimal manner. The option may range from negotiation with an interest acquirer to announcement of a public auction whichever way will be suitable to find the optimal path. But such type if optimality in auctions loses its relevance when valuation uncertainty is associated with information. Let us construct a measure of valuation uncertainty that is related with the information. A principle component analysis has been used to obtain the valuation of the level of uncertainty on the buyer’s perspective. The uncertainties have been divided into proprietary and non proprietary components. After running an analysis it can be found that the uncertainty part is not likely to be resolved even if it is disclosed during transaction but the uncertainties related to non proprietary information are ineffective on the mechanism choice. The market uncertainty theory provides an argument that efficient market prices are heterogeneous and high if there is limited source of available information. The dot.com boom or the financial instability can be treated as examples of mispricing in the market that occurred due to limited knowledge. The society was unaware about the potential impact the dot.com boom can have on the market. The characteristics of efficient markets are to use all the available information for pricing the asset in the optimal manner but associated uncertainty tends to set the price on the higher side. It was apparent that the prices during the dot.com boom were not able to hit the target. The financial crisis contributed to the changes in the financial system due to fast evaporation of the knowledge and experience. The effects were relatively similar even when injection of new innovations took place in the society. Assets exposed to higher levels of uncertainty are subjected to shocks. It is utmost necessity for the investors and regulators to keep the uncertainty exposures in mind and request for uncertainty premiums and it is believed that it is more important than risk premiums. Higher uncertainty premiums will reduce the growth of some assets and financial institutions have to incur higher costs in order to limit their exposures to these assets. The firm have to reallocate a certain portion of their budget plans to analyse the uncertainties to achieve a substantial added marginal value to be stabilise itself in the industry. Measures taken to Deal with Uncertainty The property markets around the world are characterised by lack of reliable information on which the buyers and sellers can base their decisions. The Mallinson Report in 1994 stressed on the examination of the data available in property industry asserting that the property profession has a protective nature about the related data (Wyatt and Ralphs, 2003, p.304). The Mallinson Report on commercial property valuations made 43 recommendations to improve the valuation surveyor’s standing in the business world. One of the most important recommendations was the identification and disclosure of abnormal uncertainty by the valuer (RICS, 1994, p.9). 42 recommendations of Mallinson Report were acted upon except recommendation 34, which was addressed by Carsberg Report set up by RICS in 2002. Carsberg recommended that RICS (Royal Institution of Chartered Surveyors) along with the representative bodies should establish method and format of valuation and expression of uncertainty. These recommendations were adopted by PVF, which resulted in introduction of Appraisal and Valuation Standards in 2003 by RICS also known as Red Book, in which the approaches of reporting uncertainty to client were identified as verbal reporting, statistical and ranking (French and Gabrielli, 2004, p.488). Verbal Reporting: The valuer reports the uncertainty related to valuation in written form in the report to the client. The guidance note 5 in the Red Book 2003 asserts that the opinions of valuer will increase the certainty that can vary with the property, market and information available with the valuer. There has not been any suggestion on an acceptable form of presentation or format for measurement of uncertainty. Statistical: The uncertainty in valuation is recognized through statistical information like central tendency and standard deviation. The statistical methods or quantitative methods to incorporate uncertainty are many such as probability theory and Monte Carlo simulation. Ranking: The valuation is ranked on an agreed basis. The ranking was suggested by Mallinson Committee that was meant to simply provide risk scores. The problem with ranking was it only provided whether the valuation was good or bad in terms of ranks whereas not addressing the valuation of uncertainty in valuation. Moreover, there was a likelihood of misinterpretation of the ranking by the users. Since the Mallinson and Carsberg Report, the development in the field has been profound. The RICS Red Book has till now incorporated international standards of property valuations. Additionally, London-based IVSC is an international body to promote the profession, which is engaged in the development of single global standards for valuations. There has been a global convergence of the standards and has covered 21 countries so far. In UK, application of neural networks in the property valuation was considered but never implemented. It has become a basis for automated valuation models (Blackledge, 2009, p.48). Effectiveness of Measures: The problem which was faced by Mallison report was uncertainty in valuation. The valuer must assess all the number of variables. The valuer must analyse on the appropriate comparable fields of the sale of similar properties. The transaction data of previous database will form the foundation of the analysis. It is a heuristic approach and the judgement of the valuer to his final choice will be uncorrelated to the range of the yields observed. The robustness of the database will have an influence. The observations are likely to be closely associated in a case strong markets and the range of the observed yields are likely to be small. The available data can consist of transaction dates which are to the valuation date and is also comparable to the subject property. But when the conditions of the market are likely to deteriorate there is sharp fall in the number of direct comparable sells and the valuer has no other choice but to rely on the observed transactions which are ineffective in terms of location, specification and time. The range of the observed variables is greater in this case. The appropriate yield is chosen by the valuer. The valuer will not be certain of the input data and is subjected to probability which will vary with the degree of uncertainty. It may be possible to assume some probability distribution to the variable according to the perception of the valuer. But if the properties are complex the number of variables will multiply. This is where the skill and experience of the valuer comes under the purview. There may be some criticisms which may arise from a particular group of people who have a particular use of valuation in their mind like for the financial statements or for purposes of lending. These criticisms concerned bases of valuation which are unsuitable or lack of additional information or arithmetic behind reaching the valuation. The measures of uncertainty which are based on share price volatility may be subjected to excess volatility. The availability of profit forecasts allows to evaluate another control because of the influence of future profitability which are expected. The usage of observations is also critical. Usage of few observations will imprecise the estimates while large ranges of observation will result to limited time series variation. In fast changing markets the valuer has no choice but to rely on the observed transactions. Further Possible Measures Measuring and estimating the easiest to measure: Since value is needed as an aid in order to arrive at optimal decisions, the need is to generate the amount of information required to arrive at the decision. If the easiest to measure benefits are unable to match the requirements then it is required to install additional value information which may be difficult to measure until there is no sufficient identified data or until a certain point is reached where the criteria for the change is accepted. The benefits which comes with this approach is that it saves time and resources in attempting all the benefits where the fairly easily valued are sufficient to justify the proposed change. The researcher will have to estimate or install additional value information which might be fruitful for the valuation process. But for that the valuer will have to identify the easiest way to measure the valuation. Taking into account the value of time: The forecast in today’s terms are less likely to replicate the use of that forecast in to the future. The principle is dealt using a discount factor which values future back into the present or helps in forecasting present values to be used in the future. Values obtained from this type of approaches are ready to use on an equal basis. Adjustment for poor data information: Valuation is often hampered by the uncertainty accrued to poor data validation. The information relating to data is essential to arrive at decisions. Information regarding dynamics and other basic characteristics are of prime importance as heterogeneity of composition has effects on the valuation. The decision maker can act upon some measures which may be fruitful to cope with the situation that may arise because of poor availability of data. The estimator needs to use data from similar decision situations and apply the methods to the data available with the help of proxy values and indicators. Data from similar situation can be used as proxy values in adjustment for poor information. Adjust for uncertainty over future values: Uncertainty accrued to the future values can largely affects the approaches of the valuation. Some of the researched paths that deals with the implications of uncertainty are as follows: Sensitivity analysis: It might be necessary to carry out a sensitivity analysis in order to find out the sensitiveness of the various measures of worth that is calculated with the help of estimates are to the alternative assumptions concerning to various values. If the outcome is not sensitive to fluctuations in the values of the estimated variables, then it is needless to worry about the uncertainty assumptions. Again a high sensitive variation in the outcome is the cause to worry as this implicates that more effort is required to deal with the uncertainty problem. In this analysis the key factors can be varied to find out the impacts of the variations on the measures of economic worth. The main idea behind sensitivity analysis is to cater the changes in the values of the variables. This type of approach deals with both quantity and variations in price which is around the best estimate. Sensitivity analysis measures the effectiveness of the expected values on the observed values. Sensitivity analysis means to compute the impacts of changes in the inputs on the predictions of the model. It acknowledges the fact that uncertainty exists. It is important mainly to evaluate the applicability of the model, determine the parameters and examine the behaviour of the modelled system. Focus on irreversibility: In a situation of Ceteris Paribas, more effort is needed to be given to reduce the uncertainty involved in irreversible events i.e. those events that are subjected to irreversible change, rather than the reversible ones. Avoidance of unsustainable positive activities can help to deal with uncertainty or develop some contingency plans that are effective to build alternative sources of values. If the events that are uncertain move in unexpected directions, alternative sets can be triggered right away. If the main is to achieve a sophisticated economic valuation there is need to bring in economic expertise and economic valuation effective from all ways is a complex task. Deforestation of old forest will forever preclude the wilderness benefits from the forest. The reverse may be the opposite. One can take the decision of wilderness benefits and can launch the decision of cutting in the future. Uncertainty creates comparative advantage. If uncertainty is absent then a predefined future awaits for every company and there is no competitive opportunities left to be exploited. So it cannot be concluded that uncertainty is always bad. References Standard encyclopedia of philosophy, 2008. Certainty. [online]. Available at: http://plato.stanford.edu/entries/certainty/. [Accessed 5 March, 2012]. French, N. and Gabreilli, L., 1994.Accounting for uncertainty. [Pdf]. Available at: http://www.recounsel.net/DCF_Accounting_For_Uncertainty.pdf [Accessed 5 March, 2012]. Nielson W, Mckee M, Berrens R, 2002, Value and outcome uncertainty as further explanations for the WTA vs WTP Disparity, [pdf] Available at: http://web.utk.edu/~wneilson/WTA-WTP.pdf [Accessed 5 Mrch, 2012]. Wyatt, P. and Ralphs, M., 2003. GIS in land and property management. London: Taylor & Francis. RICS, 1994. The Mallinson Report. [Pdf] Available at: http://www.rics.org/site/download_feed.aspx?fileID=6815&fileExtension=PDF [Accessed 3 March 2012]. French, N. and Gabrielli, L., 2004. The Uncertainty of Valuation. Journal of Property Investment & Finance, 22 (6), pp.484-500. [Pdf] Available at: http://www.henley.reading.ac.uk/rep/fulltxt/0705.pdf [Accessed 3 March 2012]. Blackledge, M., 2009. Introduction to Property Valuation. Oxon: Taylor & Francis. Read More