Valuation Of Securities

Chapter V
Concept of Valuation
Intrinsic value of an asset is equal to PV of benefits
(future cash streams like dividends/interest
payments) associated with it
Concept of Value:
 Book Value: accounting concept
-For an asset: historical cost less depreciation
-For debt: the outstanding amount
-For equity: assets less liabilities OR paid up equity
capital plus reserves and surplus: also called
shareholders’ funds or net worth
Concept of Valuation (contd.)
 Replacement Value: amount required to be spent by
the company to replace existing assets in current
condition
 Liquidation Value: amount a company can realize is it
sells its assets on termination of business
 Going concern Value: amount a company can realize
if it sells its business as an operating one; normally
this value is higher than liquidation value
 Market Value: current price at which the security is
being bought/ sold in the market
Valuation of Bond
Bonds are negotiable promissory notes issued by corporates/
govt. agencies; carry a specific rate of interest paid periodically;
are redeemable after a specific period
 Face Value: stated on the face of the bond, also called par
value: represents amount of borrowing by the firm
 Coupon rate of interest: thus, interest amount payable on a
bond is interest rate * face value
 Maturity period: repaid on maturity, specific time period for
which it is issued
 Redemption Value: may be at par/ premium or discount
 Market Value: at which it is traded on stock exchange
 Issue Price: may be at par, premium or discount
Valuation of Bond (contd.)
 Basic Bond Valuation Model: PV (or
discounted value) of expected interest
payments (annuities) + PV of principal
amount repayable on maturity
 For semi annual interest: divide interest
amount and discount rate by 2 and
multiply no. of years by 2
Valuation of Bond (contd.)
Bond Yield Measures:
 One period rate of return: if bond is bought and sold in a year
(Price gain/loss during holding period + interest amount) /
purchase price
 Current Yield: rate of return earned on a bond purchased at
market price
Interest amount/ Current market price
 Yield to Maturity (YTM) : rate of return earned on a bond
purchased and held till maturity; also called the discount rate
which equates PV of promised cash flows to current MP or the
purchase price
MP= PV of series of interest payments + PV of redn. Price
Alternatively, approximate YTM is:
I+(F-P)/n divided by either (.4F+.6P) or (F+P)/2
Bond Value Theorems
Relationship between required rate of
return (k) and coupon rate (r)
 If k=r, then value (MP) of bond=par
value
 If k>r, then bond value<par value, i.e.
bond will trade at a discount
 If k<r, then bond value>par value, i.e.
bond will trade at a premium
Bond Value Theorems (contd.)
Effect of number of years to maturity
on bond values
 When k>r, discount on bond declines as
maturity approaches
 When k<r, premium on bond declines
as maturity approaches
Thus, lesser the value of n, lower the
discounting effect on PVs
Bond Value Theorems (contd.)
Effect of YTM
 Bond price moves inversely proportional to its YTM (k)
 Long term bonds are more variable to changes in interest rates
than short term bonds: since YTM is cumulatively applied to
larger number of series of interest payments and principal
 Given the maturity, change in bond price is higher for decrease
in its YTM than for equal amount of increase
 For a given change in YTM, percentage price change in case of
bonds with high coupon rate will be smaller than in case of
bonds with lower coupon rates
 A percentage change in YTM affects the bonds with a higher
YTM more than it does to bonds with a lower YTM
Valuation of Warrants and
Convertibles
 Warrant: entitles the holder to buy a fixed number of shares at a
predetermined price during some specified period of time
- may expire at a certain date or may be perpetual
- may be detachable, can be traded separately
- normally work as a sweetner to issue of another base security like
debentures or preference shares
 Convertible Debentures: can be converted to equity
- partly or fully
- conversion may be optional or compulsory
- no cash paid on conversion, simply trade old security for new
- Conversion ratio
- Conversion value: conversion ratio* stock’s current MP
 Value of a convertible: PV of cash flows (interest) + PV of conversion
value
Equity Valuation: Dividend
Capitalization Approach
 Equity provides a higher return than bonds; also a
protective measure during inflation since bond prices
decline with inflation
 Value of equity share = PV of dividends received +
PV of its sale price when sold in future
 Single period valuation: for one year
 Multi Period valuation:
- for finite duration : like an annuity with fixed
dividends
- for infinite duration: like a perpetuity with fixed
dividends
Equity Valuation: Dividend
Capitalization Approach (contd.)
 Constant/ fixed dividends:
P = D/k
 With constant growth in Dividends:
P = D/ (k-g)
 With Variable growth in dividends
- PV of dividends in initial supernormal growth period
- PV of dividends in next normal growth period, then
discounted to present
- Add the two values above to get the price of equity
Impact of Growth on Price,
Returns
 As expected growth in dividend increases,
expected return depends more on capital
gains yield, less on dividend yield
 As expected growth rate in dividends
increases, P/E multiple increases
 High dividend yield and low P/E multiple
imply limited growth prospects (limited capital
gains)
 Low dividend yield and high P/E multiple
imply higher growth prospects
Equity Valuation: Ratio
Approach
 Book Value per share= net worth/ no. of outstanding equity shares
 Liquidation Value per share = (liquidating value of all assets – amount
paid to creditors and preference shareholders)/ no. of outstanding
equity shares
 Price-Earning Ratio = MP/EPS
-Hence MP of equity share=EPS X P/E multiple
-EPS= (PAT-Preference dividend)/ no. of outstanding equity shares
- Expected values (E) of EPS/PAT taken
- P/E multiple of a company based on market/industry multiple
adjusted for qualitative factors
- E (EPS) = E (dividend payout ratio)/ (k- g)
 Therefore if:
- E(P/E) > actual P/E, stock underpriced, time to buy
- E(P/E) < actual P/E, stock overpriced, time to sell
- E(P/E) = actual P/E, stock correctly priced, no action reqd.