Synopsis-10

Valuation of Shares
1. Concept of Value of Securities

Financial assets are called securities. Risk and return are the determinants of value of a
security. The present value of flows of income in future period and the ending price of a
security is known the value of the security. The security price expected at the end of
the period is difficult to predict because a number of variables influence the security
prices.

Firms raise capital by issuing securities to shareholders. Since the objective of

financial management is to maximize the shareholder value, the concept of value of
securities is important. Similarly, the cost of raising capital depends on the value of
securities.

2. Concept of Value

 Liquidation Value- Liquidation value is the amount that a company could realise
if it sold its assets, after having terminated its business.

 Going Concern Value- Going concern value is the amount that a company could
realise if it sold its business as an operating business.

 Market Value- Market value of an asset or security is the current price at which
the asset or the security is being sold or bought in the market.

3. Why are dividends important in determining the present value of a share?

How would you account for the positive market value of company's share which
currently pays no dividend?

Answer:

For shareholders in general the expected cash inflows consist only of future
dividends and. therefore, the value of an ordinary share is determined by capitalizing
the future dividend stream at an appropriate rate of discount. Secondly, shareholders
do not hold shares in perpetuity. They finally sell shares to obtain the capital gains.

A firm paying no dividends does command positive market prices for its shares since
the price today depends on the future expectation of dividends; ultimately,
shareholders will be able to realise capital gains. The dividend capitalization model is
 a valid share valuation model even for those companies which are not presently
paying dividends.

3. Share Valuation Model:

i) One Year holding period:

Present value of share (So) = +

Where, D1 = Amount of dividend expected to be received at the end of one year;

S1 = Selling price expected to be realized on sale of the share at the end of one
year;
K = Rate of return required by the investor.

ii) Multiple year holding period:

Present value of share (So) = + + …………+

Where, D1, D2, Dn = Annual dividends to be received each year;

Sn = Sales price at the end of the holding period,
K = Rate of return required by the investor.
n = Holding period in year.

iii) Constant Growth Model:

Present value of share (So) =

Where, Do = Current year dividend

g = Growth rate

iv) Multiple Growth Model:

Present value of share (So) = V1 + V2

Where, V1 = 1 to n period;
V2 = (n + 1) to infinity period
 V1 =

V2 =

Problem-01:

A share is currently selling for Tk. 65. The company is expected to pay a dividend of Tk.
2.5o on the share at the end of the year. It is reliably estimated that the share will sell for
Tk. 78 at the end of the year.

1. Assuming that the dividend and price forecasts are accurate, would you buy the
share to hold it for one year, if your required rate of return were 12 percent:
2. Given the current price of Tk. 65 and the expected dividend of Tk. 2.50, what
would the price have to be at the end of one year to justify purchase of the share
today, if your required rate of return were 15 percent?

Problem-02:

You have decided to buy 500 shares of an IT company with the intention of selling out at
the end of five years. You estimate that the company will pay Tk. 3.50 per share as
dividends for the first two years and Tk. 4.50 per shares for the next three years. You
further estimate that, at the end of the five year holding period, the share can be sold for
Tk. 85. What would you be willing to pay today for these shares if your required rate of
return is 12 percent?

Problem-03:

A company paid a cash dividend of Tk. 4.00 per share on its stock during the current
year. The earnings and dividends of the company are expected to grow at an annual rate
of 8 percent indefinitely. Investors expect a rate of return of 14% of the company’s
shares. What is a fair price of this company’s share?

Problem-04:

A company paid dividends amounting to Tk. 0.75 per share during the last year. The
company is expected to pay Tk. 2 per share during the next year. Investors forecast a
dividend of Tk. 3 per share in the year after that. Thereafter, it is expected that dividends
will grow at 10 percent per year into an indefinite future. Would you buy or sale the share
if the current price of the share is Tk. 54? Investors required rate of return is 15 percent.

Problem-05:
Mr. X has purchased a common stock from Adam & Co. The expected market value is
Tk. 370 and dividends from the stocks are Tk. 25, Tk.18, Tk. 27, Tk. 36 per year
respectively. If expected rate of return is 15 percent, what is the value of the common
stock?

(Answer- Tk. 285, apply formula no. ii)

Problem-06:

Mr. Emaul has purchased a common stock of S ltd. The company pay dividend Tk. 36
per year. When the growth rate is 6 percent and expected rate of return is 12 percent,
what is the value of the stock?

(Answer- Tk. 636, apply formula no. iii)

Problem-07:

The share of Premier Limited will pay a dividend of Rs 3 per share after a year. It is
currently selling at Rs 50, and it is estimated that after a year the price will be Rs 53.
What is the present value of the share if the required rate of return is 10 percent?
Should the share be bought?

Solution:

Expected DPS (Rs) 3.00

Current share price (Rs) 50.00
Share price after 1 year (Rs) 53.00
Required rate 0.10
PV of share (Rs):
DIV 1  P1 3  53
P = 
(1  k e )1 1 .1 50.91

Problem-08:

An investor is looking for a four-year investment. The share of Skylark Company is

selling for Rs 75. They have plans to pay a dividend of Rs 7.50 per share each at the
end of first and second years and Rs 9 and Rs 15 respectively at the end of third and
fourth years. If the investor’s capitalisation rate is 12 percent and the share’s price at
the end of fourth year is Rs 70, what is the value of the share? Would it be a desirable
investment?

Solution:
 Share price (Rs) 75.00
Capitalisation rate 0.12

Year DPS Share price (Rs) PVF PV

(Rs) at 12% (Rs)
0
1 7.50 0.8929 6.70
2 7.50 0.7972 5.98
3 9.00 0.7118 6.41
4 15.00 0.6355 9.53
4 70.00 0.6355 44.49
Value of the share 73.10

It is a desirable investment since the present value of the share is more than its current price.

Problem-09:

A company’s share is currently selling at Rs 60. The company in the past paid a
constant dividend of Rs 1.50 per share, but it is now expected to grow at 10 per cent
compound rate over a very long period. Should the share be purchased if required rate
of return is 12 per cent?

Solution:

Current share price 60.00

DPS 1.50
Growth rate 0.10
Required rate 0.12
Value of the share:
DIV 1
P0 
k e  g
1 . 5 (1 . 1 ) 1 . 65 82.5
   82 . 50
0 . 12  0 . 10 0 . 02

Share should be bought