Valuation basics

• Author: Hellwig, Martin F.
• Pages: 7-13

Valuation reports in the context of banking resolution: What are the challenges?Valuation reports in

the context of banking resolution: What are the challenges?

PE 624.417 7

VALUATION BASICS

The concept of “value” involves an exercise in counterfactuals. The assessment of value therefore

depends on which counterfactuals one considers and what assumptions one makes about them.

Importantly, the assessment of value also depends on which course of action one considers. Which

method of valuation is appropriate may therefore depend on the purpose for which the information

contained in the valuation is used.

2.1 The Counterfactual Nature of Valuations

The statement “Object x is worth y euros” refers to a potential exchange of the object against money.

As a statement from the owner, it may indicate a willingness to sell the ob ject for y euros; as a statement

from a potential buyer, it may indicate a willingness to buy it for y euros. Such statements from

interested participants however involve an important element of subjectivity, perhaps also an attempt

at manipulating the terms of an intended exchange.

The impact of subjectivity is reduced or even eliminated if the sentence is read as a statement about

trading opportunities in a market. For example, if object x is a financial asset that is traded in an

organized exchange, the statement might mean that the prevailing market price is y euros. More

generally, the “fair value” of object x is y euros, if an owner can reasonably expect to find a buyer at this

price and a potential buyer can reasonably expect to find a seller at this price.

As a statement about fair value, the sentence “Object x is worth y euros” does not presume that the

transaction in question actually takes pl ace. However, unless the transaction actually takes place, there

is no way of knowing whether it really is possible to trade the object for y euros.

When trading happens in a frictionless organized market, without information asymmetries and

without market power of participants, the counterfactual nature of valuation poses no serious problem.

Apart from the fact that overnight news may cause tomorrow’s price to be different from today’s price,

in such a market, today’s price is a fairly precise predictor of the price at which the object will be traded

in the near future.

When these conditions are not satisfied, however, the counterfactual nature of valuation can cause

serious problems. If markets are not well organized, it may be difficult to find a trading partner in

reasonable time.

Even worse, the very attempt to trade may cause the market price of the object to change. This

phenomenon arises, in particular, from effects of asymmetric information and/or market power.

Asymmetric information can give rise to the so-called “lemons” effect, whereby the very attempt of an

owner to sell an object is interpreted as a signal that the object is of poor quality.2 Such information

effects will cause the price of the object to fall as a consequence of the owner’s trying to sell it. For

example, in the context of a bank with a portfolio of non-performing loans, the very attempt to sell the

portfolio may provide the market with a signal that default probabilities are even higher than

anticipated causing potential buyers to require higher discounts.

Market power effects can occur when the trader in question is relatively large. An example would be a

central bank trying to sell its gold stock in the open market. Another example would be a corporation

2 See Akerlof (1970).