Valuation of equities, bonds, property and alternative assets
Valuation questions reward candidates who can apply a formula, state its assumptions and explain which method suits which asset.
Bonds
Price is the present value of coupons and redemption at the yield to maturity, which assumes coupons are reinvested at that yield and the bond is held to maturity. Modified duration measures first-order price sensitivity; convexity adds the second-order term. Credit analysis adds a spread: the z-spread is the constant spread over the curve, while the option-adjusted spread removes the value of embedded options - essential for callables and mortgage-backed securities.
Equities
Dividend discount model: P0 = D1/(r − g), where g = retention ratio × return on equity. Justified P/E = payout ratio/(r − g). Free cash flow models are preferred where dividends are not policy-driven; multiples such as EV/EBITDA are quick but ignore capital structure and growth differences.
Property
Income capitalisation: value = net rental income / capitalisation rate. Distinguish gross and net initial yield, reversionary yield and equivalent yield. A DCF should model rent reviews, voids, incentives, capital expenditure and an exit yield.
Alternatives
Use IRR and multiples (TVPI, DPI, RVPI) for private equity; account for the J-curve and for smoothed, appraisal-based reported returns that understate true volatility.
Worked example: duration and convexity
A bond has modified duration 7 and convexity 60. Yields rise 100bp. The duration-only estimate is −7 × 0.01 = −7.00%. Adding convexity: ½ × 60 × (0.01)² = +0.30%. The estimated price fall is 6.70%, so duration alone overstates the loss. The reasoning matters: convexity is positive, so it helps whichever way yields move, and the approximation deteriorates for large yield moves or where the bond has embedded options.
Traps
Using Macaulay duration where modified duration is required - divide by (1 + y/m). Applying a duration approximation to a callable bond. Using a trailing property yield as a total-return forecast. Applying Gordon growth with g ≥ r, or a growth rate inconsistent with the retention ratio.