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Article Excerpt
ABSTRACT
This article establishes clear theoretical distinctions between professional valuation, which focuses on assets with less than perfect liquidity (such as real estate) that are traded in private markets, and investment-financial valuation of assets exchanged in public markets. Such distinctions are illustrated by examining the widely-used techniques of the investment-financial valuation. The first part of the article reviews the concepts and processes engendered by professional valuation and its theory. The second part concerns new valuation techniques and the fundamental shift currently occurring in valuation practice.
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Worldwide discussions are underway revisiting the concepts in financial reporting and professional valuation. (1) Investment-financial valuation (IFV) includes methods of valuation flowing out of modern portfolio theory.
The objects of IFV are liquid, divisible, and mass traded, and are often denoted as financial titles, circulating on active competitive markets. Compared with IFV, professional valuation has a broader scope. It embraces assets that are not financial titles, such as real estate, specialized property, intangible assets, and other illiquid objects that are not customized and possess certain specific, unique features. The exchange of these assets is under circumstances different from the conditions in efficient markets.
The methodological basis of both areas of expertise is currently being mutually negotiated and conflated to a certain extent. Given this situation, it is important to examine the theoretical underpinnings of some of the new valuation concepts, especially where specific terms, such as fair value, may be used in a different sense in each area. (2)
New Concepts and Processes in Valuation
Certain new standards of financial reporting and valuation issued in Great Britain and the United States (countries that maintain the lead in the methodology for applied economic measurements), warn against the uncritical application in professional valuation practice of the methodologies that are based on assumptions of "effective" financial markets and "rational" economic behavior.
In Real Estate Appraisal: From Value to Worth, Sayce et al. present a brief overview of established and cutting-edge theoretical paradigms in financial economics and valuation.
Within the real estate field, the appraisal techniques that deal with assets in a portfolio context relate in the main to the conventional finance theories developed between the 1960s and 1980s. Under these theories, there has been an assumption that investment decision-making is driven by rational economic behavior and that investors have sought always to maximize returns and minimize risk. Modern portfolio theory (MPT), developed by Markowitz (1959) and subsequently extended by others, such as Sharpe, Lintner and Mossen, adopted the rational assumption. Furthermore, these authors worked on the basis that markets are "efficient," that is, that prices fully reflect all relevant financial data (see, for example, Fama and Miller, 1972). Since the mid 1980s, and some twenty years after these theories began to be applied in the financial field, property analysts have sought to use them for real estate. In the meantime, just as these "modern" finance theories have begun to gain ground within the real estate field, new theories have emerged which relax the assumptions of rationality and efficiency. New finance models accept the reality of inefficient markets and adopt a range of techniques from econometrics to arbitrage (Chen et al., 1986) and behavioral models (Tversky and Kahneman, 1981) to explain investor behavior. (3) [Emphasis added]
Sayce et al. pointedly criticize the practical application of the modern portfolio theories named after their renowned authors: Eugene Fama, nominated for the Nobel Prize several times as well as other prestigious awards; and Harry Markowitz and William Sharpe, both recipients of the Nobel Prize in 1990 for their contribution to the theory of assets pricing. The following quotes are representative of their current economic views.
Eugene Fama: "The economists should teach equilibrium but business persons should be taught to exploit disequilibrium." (4)
Harry Markowitz: "I think it is perfectly reasonable for people to ask what about the real behavior of investors as distinguished from rational behavior. I do not necessarily subscribe to each article by the behavioral economist, but it is perfectly reasonable activity to pursue." (5)
William Sharpe: "There is a constant tension between positive theory and normative theory ... you can argue fairly convincingly perhaps, for the security market line, you can argue that you ought to use the market portfolio, but we certainly cannot argue that people do this, because most people do not. So if you want to hold your positive theory up, theory not only of assets pricing, but also how people in fact choose portfolios, it obviously fails." (6)
Such views reflect the benefit of hindsight, as the fundamental theories of these living legends and their followers (who also have received Nobel Prizes for economics) have had deplorable track records. The 1997 Nobel Prize laureates, Robert Merton and Myron Scholes (who with Fisher Black developed the options pricing model), applied their theoretical convictions in real practice by investing their Nobel Prize awards in sophisticated financial schemes that in 1998 nearly led the world financial markets to the brink of unraveling. (7) In hindsight, one cannot be too fazed by their record. Real markets rarely operate in the fashion prescribed by a pure economic theory and its derivatory models, and the ideal world of theory and the real world of marketplace are not one and the same.
Practical Valuation Theory and Related Valuation Concepts
Stieglitz and an array of other Nobel Prize laureates for economics, including such prominent figures as Daniel Kahneman, Vernon Smith, and Amartya Sen, are the heralds and initiators of the global post-neoclassic movement, which theoretically rebuffs the priority of econometrics over substantive economic theory. The theoretical output of these authors is to a certain degree related to the issue of how value can be practically assessed in the real-life economy. Some economists often quote the words of 1998 Nobel Prize winner Amartya Sen, "The advance in 'pure theory' is closely connected with the development of the "practical economic theory."'
Practical valuation theory has a long history, starting with the works of Alfred Marshal, who is considered the architect of theoretically justified valuation practice. However, it is generally recognized that practical valuation theory is now undergoing a transformation within the confines of the global new economy. In the world of valuation, the interconnectedness between practical theory of valuation and pure or fundamental theory of value has grown exceedingly intricate.
It can be assumed that practical valuation theory softens the tight postulates of models based on the ideal or perfect rational economic behavior, effective markets, instant liquidity of capital assets, etc. But, of course, this entails the loss of purity in theoretical formulas or other formulations based on the axioms or paradigms assumed by researchers. This has led to endless heated debates in the area of pure economic theory.
The discussion here will not delve deeper into the problems of the paradigm shift in economics, but will address what is taking place in the disciplines attributed to practical economic theory, which can only be called normative in a very specific sense. Such a sense is now attained by the various standards of valuation, financial reporting, and audit that express the generally accepted best practices gaining wider recognition and influence in the global economy. Thus, the emerging distinguishing feature of practical valuation theory is its integral link with the standardization of professional practice; its approaches and methods; and an array of practical tools called techniques.
In recent years there has been growing recognition of the theoretically justified distinctions between valuation concepts that were introduced by Martin Hoesli and Bryan D. MacGregor. (8)
* Price is the actual observable money exchanged when a property investment is bought or sold. In most other markets price is given, but in the property market every property interest is different and requires an individual estimate of value to guide the buyer and seller in their negotiations to agree on a price. Price can be fixed by negotiation, through tender bids or at auction.
* Value is therefore an estimation of the likely selling price. In other markets, where homogenous goods are sold, the price is not estimated but is determined from market trading and is usually used to describe an assessment of worth.
* Individual worth [also known as investment value] is the true value to an individual investor using all the market information and available analytical tools and can be considered as the value in use.
* Market worth is the price a property [or any other non-homogenous illiquid] investment would trade at in a competitive and efficient market using all market information and available analytical tools. [Also termed fundamental or intrinsic value.] A valid model of calculation of market worth should reflect the underlying conditions of the market at the time. This should therefore be distinguished from market value, which accepts a less than perfect knowledge of market information. (9)
Note that two of these concepts, market worth and individual worth, are not manifested directly, and are located at various polarities of the subjective/objective continuum of economic theory.
Neoclassical market worth should be attributed to the realm of pure theory, existing subject to meeting the strictest conditions of the theoretical perfect market where such worth has a purely objective stationary meaning such that it is "market-determined," not "market determining."
Austrian-style individual worth exists subjectively, i.e., it is subject-specific and is not immediately measurable except by a procrustean bed of certain discounted cash flow investment appraisals designed to elucidate it. However, such worth is objective in its influence in that it determines whether or not to enter a transaction at a given price and, hence, determines those prices when aggregated. Paradoxically, the market-clearing, economically rational notion of market worth is ultimately price determined, while the subjective notion of individual worth is price determining.
Many practical-minded valuers regularly quote from Investment Valuation, by Aswath Damodaran. (10) In his recent fundamental theoretical paper, "Valuation Approaches and Metrics: A Survey of the Theory and Evidence," (11) Damodaran offers a weighty theoretical exposition on value estimates.
Valuation can be considered the heart of finance. In corporate finance, we consider how best to increase firm value by changing its investment, financing and dividend decisions. In portfolio management, we expend resources trying to find firms that trade at less than their true value and then hope to generate profits as prices converge on value....
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