valuation of securities -sh

7/29/2019 Valuation of Securities -SH

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VALUATION OFSECURITIES

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What is Value?

Value= Fundamental Value= Intrinsic Value

This is the value of an asset (stocks, bond, currency, gold

etc.) if all the information is know to all market disciplines

about it.

Fundamental or Intrinsic value in finance is based or

calculated as a Discounted Value.

Discounted value is the present discounted value of all

future cash flows.

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Definition of Intrinsic Value

It is the estimate of stock true value or investmentvalue based on accurate risks in other words basedon true risk and an accurate evaluation of returns.

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Need for Valuation of

Securities The objective of financial management being to

maximize the market value of equity shares,managers must know how equity shares are valued.

Understand how their investment and financingdecisions influence the value of equity shares.

Managers must also know how non equity claims arevalued.

Knowing the value of securities is also important for

investor to make decision of buy and sell.

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The Investment Decision

ProcessI. Determine the required rate of return

II. Evaluate the investment to determine if its market price is

consistent with your required rate of return

III. Estimate the value of the security based on its expected

cash flows and your required rate of return

IV. Compare this intrinsic value to the market price to decide

if you want to buy it

V. If Estimated Value > Market Price, Buy

VI. If Estimated Value < Market Price, Dont Buy

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Required Rate of Return is determined by,

1. Economys risk-free rate of return, plus2. Expected rate of inflation during the holding

period, plus

3. Risk premium determined by the uncertainty

of returns

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Two major approaches havebeen developed:

1. Discounted cash-flow valuation

Present value of some measure of cash flow, including

dividends, operating cash flow, free cash flow andresidual income

2. Relative valuation technique

Value estimated based on its current price relative to

significant variables, such as earnings, cash flow, book

value, or sales

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In this chapter

This chapter is focused on understanding the basic discounted

cash flow valuation model and its application to bond and equity

shares.

Also, it looks into non discounted cash flow approaches to

equity valuation.

Four sections:

Basic valuation model

Bond valuation

Equity valuation: dividend capitalization approach

Equity valuation: ratio approach

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Basic Valuation Model9

The value of any asset, real or financial, is equal to the present value of

the cash flows expected from it.

Using the present value technique, the value of an asset can be

expressed as,

V0= C1/(1+k)1 + C2/(1+k)

2+.+Cn/(1+k)n

V0- value of an asset at time zero

Ct- cash flow expected at the end of year t

k- discount rate applicable to the cash flows

n- life of an asset

Using the present value interest factor, PVIFk,n above equation can be

written as,


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Key Inputs10

The key inputs to the valuation process are,

1. Cash flows- Cash flow expected from any asset

may be constant or fluctuating or growing.

2. Timing- It is customary to specify the timing along

with the estimates of the cash flow.

3. Discount rate- The discount rate must be

commensurate with the risk characterizing the

cash flows.


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Bond Valuation11

Terminologies-par value, coupon rate, maturity period.

Basic Bond Valuation Model

Holder of bond receives a fixed annual interest payment for a certain

number of years and a fixed principal repayment at the time of

maturity. Hence value of a bond is,

V=n

t=1I/ (1+kd)

t + F/ (1+kd)n

V= I (PVIFAkd,n) + F (PVIFkd,n

)

V- value of bond

I- annual interest payable on the bond

F- principal amount of the bond repayable at he time of

maturity


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Example12

A Rs.100 par value bond, bearing a coupon

rate of 12%, will mature after 8 years. The

required rate of return on this bond is 15%.

What is the value of this bond?


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Bond value theorem13

Based on the bond valuation model several theorems have been

derived,

1. When the required rate of return equals the coupon rate, the

bond sells at its par value2. When the required rate of return exceeds the coupon rate, the

bond sells at a discount. However, the discount declines as

maturity approaches.

3. When the required rate of return is less than the coupon rate,

the bond sells at a premium. However premium declines as

maturity approaches.

4. The longer the maturity of a bond, the greater is its price

change in response to a given change in the required rate of


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Yield to Maturity (YTM)14

Suppose the market price of a Rs.1000 par

value bond, carrying a coupon rate of 9% and

maturing after 8years, is Rs.800. What rate of

return would an investor earn if he buys this

bond and holds it till its maturity? The rate of return that he is earns, called the

YTM is the value ofkd.


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Formula for finding approximateYTM

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YTM= [I + (F-P)/n]/ [0.4F + 0.6P]

YTM= yield to maturity

I= annual interest payment

F= par value of the bond

P= present price of bond

N= years to maturity

The price per bond of Zion limited is Rs.90. The

bond has a par value of Rs.100, a coupon rate of

14%, and a maturity period of 6years. What is the

yield to maturity?


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Bond Values with Semi-annualInterest

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Most of the bonds pay interest semi-annually. This means that the

bond valuation has to be modified along the following lines:

i. The annual interest payment, I, must be divided by two to obtain the semi

annual interest payment.

ii. The number of years of maturity must be multiplied by two to get the number

of half-yearly periods.

iii. The discount rate has to be divided by two to get the discount rate applicable

to half-yearly periods.

V=2n

t=1

(I/2)/ (1+kd/2)t + F/ (1+kd/2)

2n

V= (I/2) * (PVIFAkd/2,2n) + F (PVIFkd/2,2n)


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Example17

A Rs.100 par value bond carries a coupon rate

of 12% and a maturity period of 8 years.

Interest is payable semi-annually. Compute the

value of the bond if the required rate of return

is 14%.


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Equity Valuation:

Dividend Capitalization Approach18

According to this approach, the value of an equity

share is equal to the present value of dividends

expected from its ownership plus the present

value of the sale price expected when the equity

share is sold.


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Single Period Valuation Model19

Investor expects to hold the equity share for one

year. The price share of the equity share will be,

P0= D1/(1 + ks) + P1/(1+ks) P0 = current price of equity share D1 = dividend expected a year hence

P1 = price of share expected a year hence

ks = rate of return required on the equity share

Prestiges equity share is expected to provide a dividend of

Rs.2.00 and fetch a price of Rs.18.00 a year hence. What

price would it sell for now if the investors required rate of

return is 12%?


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What happens if the price is expected to

grow at a rate of g% annually? (if the current

price,P0, it becomes P0(1+g) a year hence)

P0= D1/(1 +ks) + P0 (1+g)/(1+ks)

P0 = D1/ (ks-g)


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Expected rate of return21

Now we look at, What rate of return can beexpected, given the current market price andforecast values of dividend and share price?

It can be given by, ks= (D1/P0 )+g

The expected dividend per share of Vaibhav Limited is Rs.5. The

dividend is expected to grow at the rate of 6% per year. If the

price per share is now Rs.50, what is the expected rate of

return?


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Multi-Period Valuation Model22

Since equity share have no maturity period,

they may be expected to bring a dividend

stream of infinite duration. Hence the value of

an equity share may be put as,

P0= D1/(1+ks)1

+ D2/(1+ks)2

+.+D/(1+ks)

-A

P0 =

t=1Dt / (1+ks)

t


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The equation A is general enough to permit any

dividend pattern- rising, declining, constant or

randomly fluctuating.

For practical application we will simplify the

above equation and it can be done in two cases,

Constant dividends

Constant growth of dividends


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Valuation with ConstantDividends

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If we assume that dividend per share remains

constant year after year at a value D, the

equation A becomes,

P0= D/(1+ks)1 + D/(1+ks)

2+.+D/(1+ks)

On simplification becomes,

P= D/ks


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Valuation with Constant Growth inDividends

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If we assume that dividends grow at a constantrate we get,

Dt = D0 (1 + g)t

Dt - Dividend for year t D0 - Dividend for year 0 g - constant compound growth rate

Example- The current dividend for an equity shareis Rs.3.00. If the constant compound growth rate is

6% what will be the dividend 5years hence?


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When the dividend increases at a constant rate

the share valuation equation becomes,

P0= D1/(1+ks)1 + D1(1+g)/(1+ks)2 +D2 (1+g)2/(1+ks)3+

If simplified, P0= D1/ks - g

E it V l ti R ti


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Equity Valuation: RatioApproach

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There are three main approaches viz.,

1. Book value approach

2. Liquidation value approach

3. Price / Earning Ratio (Earning

Capitalization Approach)


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Book Value Approach28

Book Value per share = Net worth ofcompany/Number of

outstanding equityshares

Book value can be established relatively easily.

It is based on accounting convections and policies which

characterized by great deal of subjectivity and

arbitrariness.


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Price/ Book value Ratio29

It is specified as,

Widely used to indicate how aggressively the stock is being

priced.


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Liquidation Value Approach30

The liquidation value per share is equal to,

Value realized

from liquidatingall the assets ofthe firm

Amount to be paid to

all the creditors andpreferenceshareholders

Number of all outstanding equity shares


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Earning Capitalization Approach31

This is also known as Price/Earning Ratio

The steps involved in identifying the intrinsic

value using this approach is as follows,

1. Estimate the earning per share

2. Establish an appropriate price earningmultiple

3. Develop a value anchor and value range


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Forecasting earning per share of the current

year on the basis of:

1. Published information about the company

2. The impression gathered from plant visits

3. Interview with management

1. Estimate the earning per share


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Growth prospects and risk exposure (through its

impact on the discount rate) are the key

determinants of the price earning multiple.

Other factors like, share holder friendliness of

management and liquidity of the stock.

2. Establish an appropriate price - earning

multiple


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The value anchor is obtained as follows:

Projected earnings per share x Appropriate

price

earnings multiple

3. Develop a value anchor and value range


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Assessment35

Advantages

Since the price earning ratio reflects the price per

rupee of earnings, it provides a convenient measure

for comparing the prices of share having different

levels of earnings per share.

The estimates required for using the price- earning

ratio approach are fewer in comparison to the

estimates required for dividend capitalization

approach.But it does not have a sound conceptual basis and P-E Ratio

found doesnt have a firm theoretical underpinning


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Price/ Earning ratio36

The returns investors are entitled to receive are the

firms net earnings.

One way investors can estimate value is bydetermining how many dollars they are willing to pay

per dollar of expected earnings.

For example, if investors are willing to pay 10 timesexpected ornormal earnings, a stock they expect toearn $2 per share during the following year would bevalued at $20.


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The P/E ratio is computed as,

This indicates the prevailing attitude of investors toward astocks value.

Investors must decide if they agree with the prevailing P/E

ratio (i.e., is the earnings multiplier too high or too low?)

D idi h th ili P/E


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Deciding on whether prevailing P/Eratio is too high or too low

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The spread between k and g is the maindeterminant of the size of the P/E ratio.


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Example39

A stock has an expected dividend payout of

50%, a required return of 12%, and an

expected dividend growth rate of 8%, identify

the stocks P/E ratio.

1. Multiply this P/E ratio with the expected earning

of the next year to get the estimated value of the

stock.

Wh t h if t k i h ld f 2


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What happens if stock is held for 2years and then sold?

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P0= D1/(1 + ks) + D2/(1 + ks)2 + Pj2/(1+ks)

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P0 = current price of equity share

D1 = dividend expected a year hence

Pj2 = price of share expected a 2 year hence

ks = rate of return required on the equity share

Expected selling price (Pj2) of stock j is

simply the present value of all remaining

dividend payments.


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Key Points41

Expected Rate of return =

Nominal risk free rate of return + Risk

premium

For example, for the long run, you expect a

nominal risk-free rate of about 8% and a riskpremium for this stock of 3%.Therefore, you

set your long-run required return on this stock

at 11%.

Ass mption in Di idend


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Assumption in DividendCapitalization Approach

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Dividends grow at a constant rate and this rate

will continue for an infinite period.

The required return (k) is greater than the

infinite growth rate (g). If it is not, the model

gives meaningless results because thedenominator becomes negative.

Valuation with Temporary Super


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Valuation with Temporary SuperNormal Growth

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Some firms experience periods of abnormally high rate

of growth for some finite period.

The infinite period Dividend Capitalization Approachcannot be used to value these true growth.

The Wood Company has a current dividend (D0) of $2 per share.The following are the expected annual growth rates for dividends.


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When the dividend increases at a constant rate the

share valuation equation becomes,

P0= D1/(1+ks)1 + D1(1+g)/(1+ks)

2 +D2

(1+g)2/(1+ks)3+

Where D1 - Dividend expected a year hence

Now if D0 is given what happens to the above equati


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