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SLM 54
SLM 54
DIRECTORATE OF DISTANCE
EDUCATION
MIDNAPORE-721102
M.Com.
Part – II
Paper: DCOM 201 SLM No: 054
Structure
Objectives
Relevance of the Unit
54.1 Introduction
54.2 Valuation of Different Securities
54.2.1 Valuation of equity shares
54.2.1.1 Valuation of equity share in case of single holding period
54.2.1.2 Valuation of equity share in case of multiple holding periods (say 3 years)
54.2.1.3 Valuation of equity share in case of infinite holding period
54.2.1.4 Valuation of equity share in case of constant growth rate of dividends (under
limited holding period)
54.2.1.5 Valuation of equity share in case of constant growth rate of dividends for
infinite holding period
54.2.1.6 Valuation of equity share in case of constant dividends for infinite holding
period
54.2.1.7 Valuation of equity share in case of two-stage growth rate model
54.3 Valuation of Bonds or Debentures
54.3.1 Valuation of zero-coupon bond (ZCB)
54.3.2 Concept of yield-to-maturity
54.3.2.1 Computation of YTM
54.4 Valuation of Preference Shares
Summary
Glossary
Self-assessment Questions
References
54.1 Introduction
In portfolio management, this concept of valuation holds tremendous relevance. If we look into
the topic portfolio management, we find that before portfolio management, we have security
analysis which comes in logically. This is because, in creating a portfolio, the first task is to
identify securities for purchase and sales and then to decide whether to purchase or sale at the
given price (market rate or trading price) or to wait and then transact later on. In such a bid to
take an appropriate decision, the concept of valuation comes into the picture. By valuation, we
mean application of some technique to determine the ‘should be price’ of a security. In other
words, we need to understand that rarely we find the market price to be the same as the ‘should
be price’. This ‘should be price’ is known as intrinsic value (in the parlance of investment
management). This topic of valuation aims to teach the different techniques to compute the
intrinsic value.
The need to do valuation can be explained with the help of a simple example. Suppose, you are
walking down Esplanade which is a very popular place in Kolkata for doing street shopping.
When you are strolling in the area, you find a watch displayed, the price of which is displayed as
Rs 500. Since, you are interested in buying, you look for a while and query about the price
again. When you find the reply mentioning the same price, you ask whether it can be given at Rs.
350. You continue to negotiate and finally purchase at Rs. 400. In this process, this value of Rs.
400 assigned to the watch by the person is the valuation that is done mentally. If the offer price
would be more than Rs. 400, you would not have bought the watch. Had it been settled for Rs.
380 (say), you would have definitely purchased without much negotiation as it is less than your
valuation. Thus, from this example, it might be clear that valuation concept assists people in
arriving at decisions.
In investment management, the concept of valuation is very useful. For investors, this is
necessary because only after knowing the intrinsic value (IV) and comparing it with the
market/traded price (TP), it is possible to decide whether to purchase or sale. The decision-
making is done in the following way.
The above table helps to understand the importance of the valuation concept. Due to this, efforts
are made by financial experts to do a valuation of different securities.
PY = C1 / (1+r) + C2 / (1+r) 2 + C3 / (1+r) 3 + C4 / (1+r) 4 which is the sum total of the present
value of cash flows arising from holding the security. This concept of valuation can be extended
any number of time periods and any number of cash flows. However, for cash flows extending to
infinity (theoretically), we have mathematical techniques to reduce the formula to a simpler
form.
The concept of equity valuation follows the principle as already mentioned above. But, the
determination of valuation in this is bit more difficult because of the need to predict the dividend
and the price of the share (as expected) after a certain time period.
P0=D1/(1+ke)+D2/(1+ke)2+D3/(1+ke)3+…….+Dn/(1+ke)n+ Pn/(1+ke)n………………………(1)
Pn is the expected price of the equity share at the end of period n (assuming n is the holding
period)
Using the above concept, we shall discuss the valuation concept under different situations one by
one.
P0=D1/(1+ke)+P1/(1+ke)
Solution:
P0=D1/(1+ke)+P1/(1+ke)
54.2.1.2 Valuation of equity share in case of multiple holding periods (say 3 years)
Example: Compute the valuation of the equity share of CD Ltd. in case the share will be held for
three years if it is expected that the company will declare dividends of Rs. 10, Rs. 15 and Rs. 18
in the next three years. Also, the expected sales price at the end of the third year is Rs. 225.
Assume that the cost of equity is 14%.
Solution:
= Rs. 184.33
Continuing with the above example, should you purchase the equity share of CD Ltd. if the
trading price is Rs. 165.
The answer is yes since the market rate is less than the intrinsic value (should be price). Thus, by
buying at this price, the investor will purchase at a lower rate.
In this case, we assume that the share will be held for an infinite period, thereby denoting that it
is not going to be sold. Hence, the cash flows that are expected to be received by holding the
shares are only the dividends in different years i.e. D1, D2, D3,………, Dα
P0=D1/(1+ke)+D2/(1+ke)2+D3/(1+ke)3+…….+…………..till α
By constant growth rate of dividends, we mean that if the growth factor is g (in %), then the next
year dividend will be equal to present year dividend plus g% on present dividends. For example,
if present years’ dividend is D0, D1 = D0 + g%*D0 = D0 (1+g)
54.2.1.5 Valuation of equity share in case of constant growth rate of dividends for infinite
holding period
In this case, we assume that the share will be held for an infinite period, thereby denoting that it
is not going to be sold. Hence, the cash flows that are expected to be received by holding the
shares are only the dividends in different years i.e. D1, D2, D3,………, Dα
P0=D1/(1+ke)+D2/(1+ke)2+D3/(1+ke)3+…….+…………..till α
The difference between this case and case (3) is that next years’ dividend is related to present
years’ dividend by a factor g.
Thus, D1 = D0 (1+g)
D3 = D2 (1+g) = D0 (1+g)3
P0=D1/(1+ke)+D2/(1+ke)2+D3/(1+ke)3+D4/(1+ke)4…….+…………..till α
or, P0=D0(1+g)/(1+ke)+D0(1+g)2/(1+ke)2+D0(1+g)3/(1+ke)3+D0(1+g)4/(1+ke)4…….+……till α
54.2.1.6 Valuation of equity share in case of constant dividends for infinite holding period
In this case, we assume that the share will be held for an infinite period, thereby denoting that it
is not going to be sold. Hence, the cash flows that are expected to be received by holding the
shares are only the dividends in different years i.e. D1, D2, D3,………, Dα
In this case, since the dividends are constant, the values of D1, D2, D3,………, Dα remain the
same, say D.
P0=D/(1+ke)+D/(1+ke)2+D/(1+ke)3+…….+…………..till α
= D / ke
There may be cases where the dividend growth rate does not remain the same throughout.
Instead, there can be a case where the dividend grows at a particular rate for a particular time
after which it grows at a different rate throughout.
The initial phase extends till period N during which the dividend growth rate is g1%. After this
phase, the growth rate changes to g2% which extends till infinity.
For the period from 1 to N, the phase will named as first phase for which valuation is V1.
For the next period from N+1 till infinity, the valuation will be as follows:
Solution
It is evident from the problem that it is a case of two-period growth rate. The valuation is done in
two phases - 1 and 2 for which the valuation will denoted as V1 and V2.
1. Derive the formula for equity valuation in the case of constant growth rate of
dividends for an infinite time period.
2. Calculate the intrinsic value of equity share if the present dividend is Rs. 12
and dividends are expected to grow at the rate of 10% for the next four
years. The expected sales price is Rs. 127 at the end of the four-year holding
period.
Corporate houses issue debentures to raise long-term finance which therefore also forms a
component of the capital structure. They are also traded in the secondary market. Hence, the
importance and relevance of valuation also applies to debentures as decisions to purchase or sell
depends on the comparison between trading price and intrinsic value. Bonds are similar to
In case, the bond interest is paid half-yearly, the above equation will be modified as follows:
Solution:
Trial and error method
The value of YTM can be determined using the trial and error method as follows:
Step 1: Assume an initial value of k, say 20%
The RHS value which is the sum total of all cash flows becomes Rs. 850.49
Step 2: Compare with the LHS value
Step 3: As RHS value is less than LHS value, take another value which is less than 20%, say
18%.
Step 4: Recalculate at k = 18%. We find that RHS = Rs. 906.18
Step 5: Now we apply interpolation to arrive at the value of YTM
where,
I = annual interest
M = maturity value at the end of the holding period
C = present market price of the bond
n = number of years to maturity
In the above problem, YTM can be computed as follows:
k YTM = 150 + (1000-900)/5 divided by (1000+900)/2
= 0.1789 = 17.89%
It can be seen from the two computations that the value differs. But, it will be seen that the two
values are quite close to one another.
Another concept which is closely related to bonds is that of yield to call. As the term denotes, the
concept applies to callable bonds (bonds which can be called back by the issuer before the
maturity of the bond). In cases of call, an option is given to the purchaser of the bond to
surrender the bond at the specified price (called callable price) at a specified period. Now, in
such a scenario, it is wise for the investor to decide whether to surrender or not to surrender the
bond. If the yield to call exceeds the yield to maturity, it is better to surrender the call and else
otherwise.
Q3. Compute the intrinsic value of a zero-coupon bond having face value
of Rs. 1000 which is going to mature after 4 years. Assume that the cost of
bond is 11%.
Summary
The module covers the topic of valuation of securities. It introduces the concept of valuation and
points out its relevance for investors. The readers get acquainted with the topic relating to
valuation of equity shares (under different models), bonds and special bonds like zero-coupon
bonds and preference shares.
Glossary
Intrinsic value: It is the ‘should be price’ of a security.
Zero coupon bond: It is the bond on which the coupon rate is zero.
Yield-to-maturity: It is the yield that will be enjoyed by the holder of the security if it is held till
maturity.
Self-assessment Questions
Q1. Explain the term ‘intrinsic value’ and how it is calculated?
Q2. What is yield to maturity and yield to call in the case of a bond?
Q3. How do we value bonds?
Q4. Derive the formula for equity valuation in the case of two-growth rate model.
References
a. Francis, J. C.: Management of Investments, McGraw Hill, N.Y.
b. Fischer, D. E. and Jordan, R. J.: Security Analysis and Portfolio Management, Prentice
Hall, N. Delhi.