Market value of a security is the price at which the security is traded in the market and it

is generally hovering around its intrinsic value. ... According to the fundamentalist approach to
security valuation, the value of the security must be equal to the discounted value of the future
income stream.

The process of determining how much a security is worth. Security valuation is highly
subjective, but it is easiest when one is considering the value of tangible assets, level of debt, and
other quantifiable data of the company issuing a security. For example, determining a
company's earnings for the current year is easier than determining what the value of the
company's brand recognition might be in 10 years. Valuation is important in fundamental
analysis, the practitioners of which usually consider a company's earnings to be indicative of its
value.
Valuation of Corporate Securities
In financial terms, the value of an asset derives from the cash flows associated with that asset. This
applies whether the asset is a financial asset or a real asset.
The cash flows must be evaluated on a present value basis. Thus the value of any asset at time 0
would then be the discounted value of net cash flows over a relevant time horizon.

General Valuation Model}{

V0 = C1 + C2 + ... Cn
(1+i) + (1+i) + … (1+i)n
1 2

V0 =(1+i)^-1 C1+(1+i)^-2 C2+...+(1+i)^-nCn

 V0 = Value at time 0
 C = Year’s Cash Flow
 i = Annual Interest Rate
 n = Number of Years
For instance, a three-year asset with cash flows of $2000 in year one, $3000 in year two, and
$5000 in year three would be valued at $9144 if interest is 4%.

Year Cash Flow × PVIF @ 4% = Discounted Cash Flow

1 $2000 × .962 = $1924

2 $3000 × .925 = $2775

3 $5000 × .889 = $4445

$9144
So the discounted value of the cash flows for this asset is $9144. Does this mean that the price of
the asset at time 0 would be $9144? It does if the market for the asset is efficient, So in an
efficient market, V0 = P0. Thus, to value or price an asset in an efficient market, simply identify
the cash flows associated with the asset and discount them down to present value.

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Valuing Bonds

Bonds are a corporate security representing debt of the company. They are easily valued since
the cash flows are easy to identify. The cash flows associated with bonds are the coupon
payments on the bond each coupon period and the maturity value or face value of the bond. Most
bonds pay coupons semiannually and most bonds have maturity values of $1000 each. The
following example illustrates how easily bonds are priced.

Price a 5% coupon, $1000 bond with 5 years to maturity if other bonds of similar quality are sold
to yield 8%.
The coupon payments would be $50 per year (5% of $1000) or $25 each six months. There will
be 10 compounding periods (2 × 5 years.) The maturity value is $1000. The bonds will be
discounted at the market rate which is 8% per year or 4% each six months.

Periods Cash Flow × PVIF @ 4% = Discounted Cash Flow

1-10 $25 × 8.111 = $202.78

10 $1000 × .676 = $676.00

$878.78
If one wanted to sell this bond for $980, no one would want to buy it. The only way the holder of
the bond could unload it would be to lower the price. On the other hand, if one said they would
sell the bond for $750, there would be a rush into the market to buy the bond. Thus, demand
would be greater than supply and the price of the bond would rise. To how much? To $878.78,
all other things being equal. Thus the $878.78 is the equilibrium price for the bond until market
conditions change.

Bond Yields

In the previous example the market rate of discount was 8%. That did not mean that all bonds
sold in the market had coupon rates of 8%. Rather it meant that all bonds of similar quality went
through the same auction price as the bond in the example. If the bond sold for a discount, that
would increase the yield. If it sold at a premium, that would decrease the yield, all other things
being equal. The yield to maturity is actually the internal rate of return on a bond. To find the
internal rate of return, use a financial calculator, a bond yield table, or a spreadsheet program.
However, an approximation of the yield to maturity may be found by employing the following
formula.

YTM = I + {FV - MP}{n} }{ {FV + MP}{2}}

If the investors’ required rate of return is 9%, what would be the price?

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P_{0} = \dfrac{5.25}{0.9} = \$58.33P0=0.95.25=$58.33
The yield on a share of preferred may be calculated by a simple manipulation of the pricing
formula.

k_{p} = \dfrac{D}{P_{0}}kp=P0D
So if a 3.25%, $100 par preferred were selling for $50, the investors’ required rate of return
would be 6.5%.

k_{p} = \dfrac{3.25}{50} = 0.065 = 6.5\%kp=503.25=0.065=6.5%

Valuing Common Stock

Common stock is not so easy to value. The cash flows are not stable or easily identified. One
simple model that is sometimes used to value common stock is the Gordon Dividend Valuation
Model.

P_{0} = \dfrac{D_{1}}{k_{s} - g}P0=ks−gD1

 D1 = Dividends Year 1
 ks = Investors’ Required Rate of Return
 g = Growth Rate in Dividends
D1 would be calculated by multiplying current dividends by (1 + g).
For example, price a share of common stock with current dividends of $5, a dividend growth rate
of 3% if the investors’ required rate of return is 15%.

P_{0} = \dfrac{5.15}{.15 - .03} = \$42.92P0=.15−.035.15=$42.92

D1 was found by multiplying the current dividends of $5 by 1.03 (1 + .03).
Rate of Return

Investors’ Required Rate of Return on Common Stock

By manipulating the Gordon formula, the investors’ required rate of return may be estimated.

k_{s} = \dfrac{D_{1}}{P_{0}} + gks=P0D1+g

For example, find the investors’ required rate of return on a share of common stock selling for
$100, current dividends of $3 and a dividend growth rate of 4%.

k_{s} = \dfrac{3.12}{100} + .04 = 7.12\%ks=1003.12+.04=7.12%

This overview was developed by Dr. Sharon Garrison.
No adaptation of its content is permitted without permission.

1. Markets in which prices adjust quickly to new information and prices reflect the

economic value of information.

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 2. Periodic interest payments on a bond. Usually made semiannually.

3. Par value/face value on a bond. Amount to be repaid at maturity.

4. Par value/maturity value on a bond. Amount to be repaid at maturity.

5. Price securities sell for in efficient market, which is the discounted value of cash

flows.

6. Selling below par.

7. Selling in excess of par.

8. Return on bond if held to maturity. Reflects premium/discount and price and

maturity of bond.

9. Rate of return that causes net present value to equal 0.

10. Ownership interest in the firm.

Valuation of Securities (With Formula)

Debenture Valuation:
A bond is an instrument of debt issued by a business house or a government unit. The bonds may
be issued at par, premium or discount. The par value is the amount stated on the face of the bond.
It states the amount the firm borrows and promises to repay at the time of maturity. The bonds
carry a fixed rate of interest payable at fixed intervals of time. The interest is calculated by
multiplying the value of bonds with the rate of interest.

Bond valuation is, generally, called debt valuation because the features that distinguish bonds
from other debts are primarily non-financial in nature. Since bonds have a promised payment
stream, they are less risky as compared to the shares. But it does not mean that they are totally
risk free. Therefore, the required rate of return on a firm’s bond will exceed the risk-free interest
rate but will be less than the required rate of return on shares. The differences in required rates of
return among bonds of different companies are caused by differences in ‘default risk’. The value
of the bond depends upon the discount rate. It will decrease with every increase in the discount
rate.

For the purpose of valuation, bonds may be classified into two categories:
(i) Bonds with a maturity period, and

(ii) Bonds in perpetuity.

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(i) Bonds with a Maturing Period:
When the bonds have a definite maturity period, its valuation is determined by considering the
annual interest payments plus its maturity value.

The following formula can be used to determine the value of a bond:

where, Vd = Value of bond or debt

R1, R2……. =Annual interest (Rs.) in period 1, 2, …, and so on
Kd = Required rate of return
M = Maturity value of bond

n = Number of years to maturity.

It must be observed from the above equation that as n becomes large, it becomes difficult to
calculate (1 + kd)n.
Symbolically:
Vd =(R)(ADFi, n) + (M)(DFi, n)

Illustration 1:
An investor is considering the purchase of an 8% Rs. 1,000 bond redeemable after 5 years at par.
The investor’s required rate of return is 10%. What should he be willing to pay now to purchase
the bond?

Solution:
8% * 1000 = 80
80 * PVFA5,8% + 10000 *

Bonds Redeemable in Installments:

A company may issue a bond or debenture to be redeemed periodically. In such a case, principal
amount is repaid partially each period instead of a lump sum at maturity and hence cash outflows
each period includes interest and principal. The amount of interest goes on decreasing each
period as it is calculated on the outstanding amount of bond/debenture.

The value of such a bond can be calculated as below:

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Illustration 2:
A company is proposing to issue a 5 year debenture of Ksh1,000 redeemable in equal
installments at 14 percent rate of interest per annum. If an investor has a minimum required rate
of return of 12 per cent, calculate the debenture’s present value for him. What should he be
willing to pay now to purchase the debenture?

Solution:

(ii) Bonds in Perpetuity:

Perpetuity bonds are the bonds which never mature or have infinitive maturity period. Value of
such bonds is simply the discounted value of infinite streams of interest (cash) flows.

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where, Vd = Value or bond or debt
Kd = Required rate of return

R1 = Interest at period 1
R2 = Interest at period 2
R = Annual Interest (as interest is constant)

Illustration 3:
Mr. A has a perpetual bond of the face value of Rs. 1,000. He receives an interest of Rs. 60
annually. What would be its value if the required rate of return is 10%?

Solution:
Vd = R/Kd
= 60/10

= Rs. 600

Relationship between the Required Rate of Return and Coupon Interest Rate:
We have observed earlier that the value of a bond or debenture is influenced by the coupon or
fixed rate of interest payable on the bond and the investor’s required or desired rate of return.

The relationship between the required rate of return and the coupon interest rate can, thus,
be summarised as below:
(i) If the investor’s required rate of return and the coupon interest rate are the same, the value of
the debt (bond or debenture) shall be equal to its face value or paid-up value, as the case may be.

(ii) If the required rate of return is higher than the interest rate payable on bond or debenture, the
value of the bond shall be lower than its face or paid-up value.

(iii) If the required rate of return is lower than the interest rate payable on bond or debenture, the
value of the bond shall be higher than its face or paid-up value.

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The above relationship can be explained with the help of following illustration.

Illustration 4:
Face value of a Debenture = Rs. 1,000

Annual Interest Rate of Debenture = 12%

Maturity Period = 5 years

What is the value of the debenture, if:

(a) Required rate of return is 12%

(b) Required rate of return is 15%

(c) Required rate of return is 10%

Solution:
Vd = (R) (ADFi,n) + (M)(DFi,n)
Vd = 120(3.605) + 1000 (.567)
Or, Vd = 432.60 + 567
= Rs. 999.60 or say Rs. 1,000.

(b) Vd = 120 (3.352) + 1,000 (.497)

= 402.24 + 497

= Rs. 899.24

(c) Vd = 120 (3.791) + 1,000 (.621)

= 453.92 + 621

= Rs. 1075.92 or say Rs. 1076

Bond Values with Semi-Annual Interest Rates:

We have so far determined the valuation of debentures considering the annual interest payments
for the sake of simplicity. However, in most of the cases, interest is payable on semi-annual or
half yearly basis.

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To determine the value of such bonds/debentures, the bond valuation equation has to be
modified on the following lines:
(1) The annual interest amount, R, should be divided by 2 to find out the amount of half-yearly
interest.

(2) The maturity period, n, should be multiplied with 2 to get the number of half yearly periods.

(3) The required rate of return, Kd, should be divided 2 to get an appropriate discount rate
applicable to half-yearly periods.
Thus, the basic bond valuation equation as modified would be:

Illustration 5:
An investor holds a debenture of Rs. 100 carrying a coupon rate of 12% p.a. The interest is
payable half-yearly on 30th June and 31st December every year. The maturity period of the
debenture is 6 years and it is to be redeemed at a premium of 10%. The investor’s required rate
of return is 14% p.a. Compute the value of the debenture.

Solution:
Vd = (R/2)(ADFi/2,2n) + M (DFi/2,2n)
12/2(7.943) + 110(.444)

47.658 + 48.840

Rs. 96.498 or say Rs. 96.50

Yield to Maturity or Bond’s Internal/Rate of Return:

We have so far assumed that the investor’s required rate of return, also called the discount rate, is
given for calculating the value of the bond/debenture. However, in many cases, we may be
required to calculate the required rate of return when the cash inflows and the current value/price
of the bond are given.

This rate also known as ‘yield to maturity’ or ‘the internal rate of return’ for the bond can
be calculated by solving the following basic equation:
Vd = R1/(1 + kd)1 + R2/(1 + kd)2 + – – – Rn/(1 + kd)n

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For example, suppose that the current value of a 8% debenture, of Rs. 1,000 redeemable after 5
years at par, is Rs. 924.28.

The yield to maturity or the internal rate of return can be calculated as below:
924.28 = 80/(1 + kd)1 + 80/(1 + kd)2 + 80/(1 + kd)3 + 80/(1 +kd)4 + 80/(1 + kd)5 + 1000/(1 + kd)5
We can find the value of kd equal to 10 percent from the above equation by trying several values
of Kd by hit and trial method. At 10% the equation becomes:
= 80(3.791) + 1000(0.621)

= 303.28 + 621

= 924.28

However, the approximate value of yield to maturity can also be found by using the
following simple formula:
Ydm = I + (F-V)/n/0.4F + 0.6V
where, I = Annual interest payment

F = Face value of bond/debenture

V = Current value/price of bond

n = Number of years to maturity

Thus, in the above example, the yield to maturity can be calculated as:
Ydm = 80 + (1000-924.28)/5)/(4/10 × 1000) + (6/10 × 924.28)
= 95.14/954.57

= 10% (appx.)

In case of perpetual or irredeemable bonds/debentures, the yield to maturity can be

calculated by using the following simple equation:
Vd = R/kd or kd = R/Vd
where Vd = Value of debenture
R = Annual interest payment

kd = Required rate of return or yield to maturity.

Illustration 6:

Page 10 of 31
Mr. A has a perpetual bond of the face value of Rs. 1000. He receives an interest of Rs. 60
annually. Its current value is Rs. 600. What is the yield to maturity?

Solution:
Vd = R/kd
or kd = R/Vd
or kd = 60/600 = .10
Thus, the yield to maturity is 10%.

Valuation of Zero Coupon/Deep Discount Bonds (DDBs/ZCBs):

The deep discount bond does not carry any interest but it is sold by the issuer company at deep
discount from its eventual maturity (nominal) value. The Industrial Development Bank of India
(IDBI) issued such DDBs for the first time in the Indian capital market at a price of Rs. 2700
against the nominal value of Rs. 1,00,000 payable after 25 years.

Since there is no intermediate payment of interest between the date of issue and the maturity
date, these DDBs may also be called zero coupon bonds (ZBBs).

The valuation of a deep discount bond can also be made in the same manner as that of the
ordinary bond or debenture. The only point to remember is that there shall be only one cashflow
at the time of maturity in case of a deep discount bond.

Thus, the value of a DDB may be taken as equal to the present value of this future cashflow
discounted at the required rate of return of the investor for number of years equal to the life of
the bond.

The following formula can be used to determine the value of a DDB:

Vddb = FV/(1+rn)
where Vddb = Value of a deep discount bond
FV = Face value of DDB payable at maturity

r = Required rate of return

n = Number of years to maturity/Life of DDB.

We can also make use of the present value tables to simplify our calculations.

Symbolically:
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Vddb = (FV) x (DFi,n)
Illustration 7:
A deep discount bond (DDB) is issued for a maturity period of 20 years and having a face value
of Rs. 1,00,000. Find out the value of the DDB if the required rate of return is 10%.

Solution:
Vddb = FV/(1+r)n = (FV) × (DFi,n)
= 1,00,000/(1 + .10)20
= (1,00,000) × (.14864)

= Rs. 14,864.

Share Valuation:
Preference share is a hybrid security having features of both equity and debt. A fixed rate of
dividend is paid on preference shares. Dividend on preference share is payable out of profits after
paying interest on debt but before paying dividend on equity shares.

A preference share is also preferred in repayment as compared to equity share. Thus, preferred
share is riskier than the bond but less risky than the equity share. The required rate of return on
preferred stock is, therefore, greater than that of bonds.

Preferred stock or share can be with a maturity period or redeemable after a certain period or
with perpetuity having no maturity period. The valuation of a preference share is very much
similar to the valuation of a bond. The following formulas can be applied to find the value of an
preference share.

Value of a Redeemable Preference Share:

Vd = d/(1 +kp)1 + d/(1 + kp)2 + … … … d/(1 +kp)n Pn/(1 +kp)n
where, Vp = Value of preference share
d = Annual dividend per preference share

Pn = Maturity or redemption price of preference share

Kp = Required rate of discount on preference share.
Illustration 8:
Mr. A is considering the purchase of a 7% preference share of Rs. 1,000 redeemable after 5 years
at par. What should he willing to pay now to purchase the share assuming that the required rate
of return is 8%?

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Solution:

Value of a Perpetual Preference Share:

If the preference share has no maturity date or is irredeemable and the future dividends
are expected to be constant, the value can be calculated as below:
Vp = d/kp
where, Vp = Value of preference share
d = Constant annual dividend

kp = Required rate of discount or return on preference share.

Illustration 9:
Mr. A has a irredeemable preference share of Rs. 1,000. He receives an annual dividend of Rs.
80 annually. What will be its value if the required rate of return is 10%?

Solution:
Vp = d/kp
= 80/0.10

= Rs. 800

Equity Share Valuation:

The valuation of common stock or equity shares is relatively difficult as compared to the bonds
or preferred stock. The cash flows of the latter are certain because the rate of interest on bonds
and the rate of dividend on preference shares are known. The cash flows expected by investors
on common stock are uncertain. The earnings and dividends on equity shares are expected to
grow.

However, we can determine the value of equity shares:

(i) By developing certain models based on capitalisation of dividend, and

(ii) Capitalisation of earnings. Dividend capitalisation models are the basic valuation models.

Page 13 of 31
Valuation Analysis

What Is Valuation Analysis?

Valuation analysis is a process to estimate the approximate value or worth of an asset, whether
its a business, equity, fixed income security, commodity, real estate, or other assets. The analyst
may use different approaches to valuation analysis for different types of assets, but the common
thread will be looking at the underlying fundamentals of the asset.

Understanding Valuation Analysis

Valuation analysis is mostly science (number crunching), but there is also a bit of art involved
because the analyst is forced to make assumptions for model inputs. The value of an asset is
basically the present value (PV) of all future cash flows that the asset is forecasted to produce.
Inherent in the estimation model for a company, for example, is a myriad of assumptions
regarding sales growth, margins, financing choices, capital expenditures, tax rates, discount rate
for the PV formula, etc.

Once the model is set up, the analyst can play with the variables to see how valuation changes
with these different assumptions. There is no one-size-fits-all model for assorted asset classes.
Whereas a valuation for a manufacturing company may be amenable to a multi-year DCF model,
and a real estate company would be best modeled with current net operating income (NOI)
and capitalization rate (cap rate), commodities such as iron ore, copper, or silver would be
subject to a model centered around global supply and demand forecasts.

How Valuation Analysis is Used

The output of valuation analysis can take many forms. It can be a single number, such as a
company having a valuation of approximately $5 billion, or it could be a range of numbers if the
value of an asset is largely dependent on a variable that often fluctuates, such as a corporate bond
with a high duration having a valuation range between par and 90% of par depending on the
yield on the 30-year Treasury bond. Valuation can be expressed as a price multiple. For example,
as a tech stock is trading at a price-to-earnings (P/E) multiple of 40x, a telecom stock is valued at
6x enterprise value-to-earnings before interest, taxes, depreciation and
amortization (EV/EBITDA) or a bank is trading at 1.3x price-to-book (P/B) ratio. Valuation
analysis can also take the final form of as asset value per share or net asset value (NAV) per
share.

Valuation and Intrinsic Value

Valuation analysis is important for investors to estimate intrinsic values of company shares in
order to make better-informed investment decisions. Fair values of bonds do not deviate much, if
at all, from intrinsic values, but opportunities do arise once in a while in the case of financial
stress of a heavily indebted company. Valuation analysis is a useful tool for comparing
companies within the same sector or estimating a return on an investment over a given time
period.

Security Valuation: Meaning and Factors | Financial Economics

Meaning of Security Valuation:

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Security valuation is important to decide on the portfolio of an investor. All investment decisions
are to be made on a scientific analysis of the right price of a share. Hence, an understanding of
the valuation of securities is essential. Investors should buy underpriced shares and sell
overpriced shares. Share pricing is thus an important aspect of trading. Conceptually, four types
of valuation models are discernible.

They are:
(i) Book value,

(ii) Liquidating value,

(iii) Intrinsic value,

(iv) Replacement value as compared to market price.

(i) Book Value:

Book value of a security is an accounting concept. The book value of an equity share is equal to
the net worth of the firm divided by the number of equity shares, where the net worth is equal to
equity capital plus free reserves. The market value may fluctuate around the book value but may
be higher if the future prospects are good.

(ii) Liquidating Value (Breakdown Value):

If the assets are valued at their breakdown value in the market and take net fixed assets plus
current assets minus current liabilities as if the company is liquidated, then divide this by the
number of shares, the resultant value is the liquidating value per share. This is also an accounting
concept.

(iii) Intrinsic Value:

Market value of a security is the price at which the security is traded in the market and it is
generally hovering around its intrinsic value. There are different schools of thought regarding the
relationship of intrinsic value to the market price. Market prices are those which rule in the
market, resulting from the demand and supply forces. Intrinsic price is the true value of the
share, which depends on its earning capacity and its true worth. According to the fundamentalist
approach to security valuation, the value of the security must be equal to the discounted value of
the future income stream. The investor buys the securities when the market price is below this
value.

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Thus, for fundamentalists, earnings and dividends are the essential ingredients in determining the
market value of a security. The discount rate used in such present value calculations is known as
the required rate or return. Using this discount rate all future earnings are discounted back to the
present to determine the intrinsic value.

According to the technical school, the price of a security is determined by the market demand
and supply and it has very little to do with intrinsic values. The price movements follow certain
trends for varying periods of time. Changes in trend represent the shifts in demand and supply
which are predictable. The present trends are the offshoot of the past and history repeats itself
according to this school.

According to efficient market hypothesis, in a fairly large security market where competitive
conditions prevail, market prices are good proxies for intrinsic values. The security prices are
determined after absorbing all the information available to market participants. A share is thus
generally worth whatever it is selling for in the market.

Generally, fundamental school is the basis for security valuation and many models are in use,
based on these tenets.

(iv) Replacement Value:

When the company is liquidated and its assets are to be replaced by new ones, their prices being
higher, the replacement value of a share will be different from the Breakdown value. Some
analysts take this replacement value to compare with the market price.

Factors Influencing Security Valuation:

Security price depends on a host of factors like

i. Earnings per share

ii. Prospects of expansion
iii. Future earnings potential
iv. Possible issue of bonus or rights shares, etc.

Some demand for a particular stock may give pleasure of power as a shareholder or prestige and
control on management. Satisfaction and pleasure in the non-monetary sense cannot be
considered in any practical and quantifiable sense. Many psychological and emotional factors
influence the demand for a share.

Page 16 of 31
In money terms, the return to a security on which its value depends consists of two
components:
(i) Regular dividends or interest, and

(ii) Capital gains or losses in the form of changes in the capital value of the asset.

If the risk is high, return should also be high. Risk here refers to uncertainty of receipt of
principal and interest or dividend and variability of this return.

The above returns are in terms of money received over a period of years. But money of Re. 1
received today is not the-same as money of Re. 1 received a year hence or two years hence etc.
Money has time value, which suggests that earlier receipts are more desirable and valuable than
later receipts. One reason for this is that earlier receipts can be reinvested and more receipts can
be got than before. Here the principal operating is compound interest.

Thus, if Vn is the terminal value at the period n, P is the initial value, g is rate of compounding or
return, n is the number of compounding periods, then Vn = P (1 + g)n.
If we reverse the process, the present value (P) can be thought of as reversing the compounding
of values. This is discounting of the future values to the present day, represented by the formula-

P = Vn /(1+ g)n

where the meaning of the terms used is the same as indicated above.
The major factor which influences security prices is the return on equity capital to the investor.
This return may be in the form of dividends or net earnings of the company. Thus, the value of a
share is a function of the company’s dividend paying capacity or its earnings capacity. The
dividends may be different from the earnings depending on the amount of profits retained by the
company for the requirements of liquidity, expansion, modernization, etc.

Normally, the value of a share is its book value, if the shares are not quoted on the market. On
the other hand, the market price of shares quoted will differ from the book value based on
investors’ perception of the future earning potential of the company, growth prospects and the
industry prospects, quality of management, the goodwill or the intangibles of the company.

If the security is a bond or debenture and has a fixed return like 14% per annum, its market price
depends upon investor’s perception of the capitalization rate which may be assumed to be 15%.

Page 17 of 31
In this case-

If the security is an equity share, its return is Dividend + Capital appreciation. Then the future
dividends may not be constant or fixed as also the degree, of capital appreciation.

Graham’s Approach to Valuation of Equity:

In their book on Security Analysis (1934) Benjamin Graham, and David Dodd, argued that future
earnings power was the most important determinant of the value of stock. The original approach
of identifying the undervalued stock is to find out the present value of forecasted dividends, and
if the current market price is lower, it is undervalued. Alternatively, the analyst could determine
the discount rate that makes the present value of the forecasted dividends equal to the current
market price of the stock. If that rate (I.R.R. or discount rate) is more than the required rate for
stocks of similar risks, then the stock is underpriced.

Graham and Dodd had argued that each dollar of dividends is worth four times as much as one
dollar of retained earnings (in their original Book); but subsequent studies of data showed no
justification for this. Graham and Rea have given some questions on Rewards and risks for
financial data analysts to answer yes or no and on the basis of these ready to answer questions,
they decided to locate undervalued stocks to buy and overvalued stocks to sell.

Such readymade formulas or questions are now out of favour due to various empirical studies
which showed that earnings models are as good as or better than dividend models and that a
number of factors are ably studied for common stock valuation and no unique formula or answer
is justifiable.

The Net Asset Value of a company (NAV) = Total assets less liabilities, borrowings, debts,
preference capital and contingent liabilities which is to be divided by the number of shares.

The (PECV) is obtained by capitalising the average profits after tax (over the past three years) by
a rate varying from 15% to 20% depending on the nature of the activity of the company.
The fair value of the share is the average of the NAV and PECV. This Fair Value (FV) is taken
into account for comparison with the average market price over the preceding three years and the
average market price should be less than the fair value by at least 20%. If the average market
price is 20% to 50% of the FV, the capitalisation rate to be used is 12%. If it is 50% to 75% of

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the FV, the capitalisation rate is 10% and if it is more than 75% of FV, the capitalisation rate is
8%.

Example:
This example will make the above exercise clear (year 1990).

Take a manufacturing company (TISCO)

Average Market Price over the last three years = Rs. 123

Net Asset Value (NAV) computed as shown above = Rs. 68

Profit-Earning Capacity Value (PECV) = Earnings per share Rs. 5.4

capitalised by 15% for manufacturing company = 5.4×100/15 = Rs. 36.

Average of NAV and PECV is (68 + 36)/2 = Rs. 52 which is the fair value.

The market price is more than 75% of the Fair Value (Rs. 52). Hence, the capitalisation rate of
8% is to be applied as referred to above to the earnings per share.

Earnings per share is Rs. 5.4.

At the capitalisation rate of 8%, the PECV = Rs. 67.50.

Book value per share or NAV is Rs. 68.

The average of the two above is Rs. 67.75.

For a share of Rs. 10 of face value, the premium is thus Rs. 57.75.

Since May 1992, with the repeal of C.I.C. Act, free market pricing of shares has been permitted.
The price of new issue can be decided by the company and its Merchant banker. As per the
existing guidelines of SEBI, the merchant banker need not submit the proposals regarding the
share price, premium, if any, etc. of new issues to the SEBI for vetting, but the justification for
the same is to be provided in the prospectus. A margin of 20% on either side is permitted to
change the actual premium from the premium submitted to SEBI for record or vetting.

Valuation of Securities: 6 Pricing Models | Securities | Financial Economics

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1. Constant Growth Model:
For equity securities, the market price depends upon the discounted future dividends or earnings
flows and the rate of growth of dividends. Thus, P = Value = D/K-g , D = Expected dividend K =
Discount rate g = Rate of growth of earnings power.

In this simplified model, dividend flows are assumed to be constant and the rate of growth of
earnings fixed.

The discount rate in the above model is subjective and is assumed to be a specific rate such as
risk-free market rate or the long-term yield rate on government bonds. A few analysts use the
implied discount rate or internal rate of return, which is derived by equating the present value of
the projected dividend stream with the current market price.

The actual selection of the discount rate as the fair rate of return on capital is a concept which is
to be defined by the analysts and used as a subjective factor. Many people use a crude
discounting model whereby the dividend stream is constant and the discount rate is also fixed as
the internal rate of return on the project. In actual fact, the discount rate is a rate on fixed income
securities, which are risk-free like government bonds. The yield on Government bonds at 11-
12% is taken normally as the risk-free rate in India. But some use the bank rate of 9% as a risk-
free return.

Equity Valuation:
The intrinsic value of an equity share depends on the dividends declared by the company.

These models can be broadly classified for simplicity’s sake into:

(i) Single-period valuation models; and

(ii) Multi-period valuation models.

In these models, the infinite stream of future dividends is valued for the present time as price-
dividend ratio. If the net earnings are assumed to be the same as dividends and no retained
earnings, then the price-dividend ratio contracts to price-earnings ratio.

(i) Single-Period Valuation Models:

Assume that — (i) the dividends are paid annually; (ii) the first dividend is received after one
year, and (iii) the resale occurs at the end of the year. Then, the price of the share is Po =

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D1/(1+i) + P1/(1+i) where Po is the current price, P 1 is the price after a year, D1 is the dividend
after a year and i is the required rate of return.
Example:
A company’s equity share is expected to bring a dividend of Rs. 2 and fetch a price of Rs. 18
after a year. If the investor buys at Rs. 18, there is no capital appreciation. Assuming the required
rate of return to be equal to 12%,

If the investor purchases at Rs. 18, he incurs a loss of Re. 0.14 on every share.

(ii) Multi-Period Share Valuation Model:

An investor would hold the security for more than one period. In this case, the price of the share
is given by the formula-

Where, Di is the dividend in period I and Pn is the selling price. In case the dividends grow at a
constant rate of g, the equation reduces to-

Example:
The expected earnings per share is Rs. 3 and dividend Rs. 2 respectively. If the required rate of
return is 15%, what should be the share price assuming g = 0%, 5% and 10%.

Therefore, when g = O, P = 2/0.15 = 13.33

when g = 0.05, P2/0.15-0.05 = 20

when g = 0.10, P =2/0.15 – 0.1 = 40

The above example shows how the share price appreciates very high, if the company evinces
growth prospects and declares rising dividends.

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2. Two Stage Dividend Model:
The model for the stock price is given as follows: Here D 1 is the dividend in the initial year and
D j is dividend in terminal year.
ADVERTISEMENTS:

Here we assumed that dividends will grow at a constant rate for ever and the Stock’s required
return is greater than the dividend growth rate which means K > g.

Sometimes the growth rate can be negative when cash dividends are declining in some years.
Even so, the above equation can be applied.

The above equation cannot be applied when the dividend growth rate changes after some years,
g1 and g2 are two growth rates in two periods, when the two-stage growth model can be set out
as-

DN stands for dividend per share in time period N and N is number of years that g 1 growth rate
lasts.
Example:
A company “xyz” has experienced a growth rate of 20% for 5 years and then it fell to a more
normal level of 6%. The company’s last dividend was Re. 0.50 per share. The required return is
15%.

Here g1 = 20%, g2 = 6%, Do = 0.50

K = 15% or 0.15, N = 5

Applying the above equation, we have-

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3. Dividend Capitalisation Model:
Sometimes, the firms do not declare dividends so as to finance their future programmes. In such
cases, the dividends are non-existent, but the market prices may be high. In these cases, it is seen
that the investors use earnings as a proxy for dividends in the above models. The dividend
capitalisation model and the earnings capitalisation model yield the same result only when all the
earnings are paid out as dividends. Then there is no growth. P = E 1/i where the earnings (E1) (or
dividends) grow at a constant rate, then the formula is P = E1/i-g.
When a portion of the earnings is retained, the dividend capitalisation model is to be used. When
growth in the expected future dividends is taken as a function of retained earnings that are
reinvested in profitable projects, it is double counting to include both the earnings and the future
growth rate of dividends in the same model as the latter depend upon the former also, in part.

4. Earnings Capitalisation Model:

It is to be noted that higher future dividends are an alternative to present dividends and are not an
addition to the present dividend stream. If E = D, the firm cannot grow. Thus, the investors who
use the price-earnings ratio tend to overstate the market price due to the double counting
problem.

In reality, the earnings do not grow at a constant rate nor do the dividends. For theoretical nicety,
these assumptions are made. But as limitations, it should be noted that the desired rate of return
and the actual rate may not coincide and there is an element of subjectivity in the desired rate of
return. Besides, the use of price-earnings ratio following the dividend capitalisation model,
suffers from the fact that earnings data are historical but price is the present price, which already
takes into account the past dividends, and the future dividend flow may not depend on the past
earnings, and price is paid for the future returns.

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Use of P/E Ratio:
Many practising analysts use the simple multiplier technique of P/E ratio, but not the present
value models referred to above.

The ratio P/E = Current Market Price/Earnings per share.

By an analysis of the company’s performance, the analyst computes the P/E multiplier (the times
P is higher than the earnings per share). In this case, he forecasts the future earnings per share for
the next six months or one year and uses this historical multiplier of the same company or of the
industry average multiplier to arrive at the market price. The resulting market price is compared
with the actual market price to find out whether it is overpriced or underpriced. If it is
overpriced, it is to be sold as per the principles of trading operations based on fundamental
analysis.

The valuation technique based on discounting is cumbersome and serious forecasting problems
arise in the process. The discount rate to be used is a subjective factor and a number of
assumptions are required to be made regarding the dividend flows in the present value models.
Therefore, analysts and investors use only the P/E ratio for security valuation in practice.

To sum up, the models more commonly used for security pricing are the Dividend Discounting
method/Earnings Discounting method and the P/E ratio model.

Dividend Discounting Method:

The expected future dividend payments by the company are discounted to the present day by the
use of an appropriate discount rate, which is supposed to reflect the magnitude of risk-free
return. The risk premium of stocks may have some risk element and many additional
uncertainties. In this model, each of the future year’s dividend up to, say, for ‘n’ years (10 years)
is discounted with the appropriate discount rate to the present and summed up to arrive at the
worth of the stock today. Dividends are expected to remain constant and the discount rate is
assumed to remain unchanged.

In this simplified model, no provision is made for changes in dividend or for a variable growth of
dividend/ earnings. The formula is D/K – g, where D is the dividend, k is the discount rate and g
is the constant growth rate of dividends. In this model, the discount rate is a matter of individual
perception and is subjective. It is based on the expected depreciation of the rupee and one’s own
time premium of the present over the future. Thus, today one rupee may be worth Rs. 1.10 in the
next year (a premium of 10 per cent inclusive of inflation).

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5. P/E Ratio Model:
The present value of the stock is also arrived at through the assumed relationship between the
P/E ratio of a company and that of the average of the whole industry in which the company is. If
the company’s P/E ratio and the industry P/E ratio have some relationship, these can be related to
derive the industry relative, which can be applied to the company’s earnings per share to arrive at
its price. Thus, if P/E for Tea industry has a P/E relative at 15, then for the company in Tea
industry say Tata Tea, data on earnings per share can be multiplied by 15 to arrive at its price. If
this price is higher than the market price, the security is undervalued and vice versa.

6. Other Models:
Some writers speak of two supplementary guides to valuation which came into fairly wide use,
namely, price-to-asset ratio and price-to-sales ratio. According to the first, the stocks of a
company are evaluated by reference to the true net asset values using various capital goods and
inventory price indices to adjust reported book values. A number of analysts define this as the
replacement cost or book value of the company. Some take it as the net working capital per share
measured by current assets minus current liabilities, fixed assets minus long-term debt and
preferred stock minus intangible assets divided by the number of shares. This is something like
the breakdown value of the company’s assets.

QUESTION ONE
(a) Examine four assumptions of the Modigliani and Miller (MM) dividend irrelevance Theory.
(4 marks)

(b) Differentiate between the following terms as applied in finance:

“Operating leverage” and “financial leverage”. (2 marks)
“Cum-right ’ and “ex-right” market price per share. (2 marks)
“Time value of money” and “time preference for money”. (2 marks)

(c) The fixed operating cost for Gahaleni Pharmaceutical Ltd. are Sh.5.8 million per annum and
the variable cost ratio is 0.20.
Additional information:
The company has Sh.2 million in bonds outstanding with an annual coupon interest rate of 8 per
cent.

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The company has 30,000 preference shares outstanding which pay Sh.2 dividend per share each
year.
The company has 100,000 ordinary shares outstanding.
Revenues of the company are Sh.8 million per annum.
The company is in the 30% corporate tax bracket.
Required:
The degree of operating leverage. (4 marks)
The degree of financial leverage. (3 marks)
The degree of combined leverage. (3 marks) (Total: 20 marks)

QUESTION TWO
(a) Describe four limitations of the net present value (NPV) method of investment appraisal. (4
marks)
(b) The management of Bundacho Limited is in the process of evaluating two projects, namely
Alpha and Beta.
The estimated pre-tax cash flows of each of the projects are as follows:
Year Project Alpha Project Beta
Pre-tax cash flows Pre-tax cash flows
Sh. “000” Sh. “000”
1 2,590 4,300
2 2,880 3,290
3 3,050 3,200
4 2,950 3,700
5 – 4,850
6 – 4,420

Additional information: Project Alpha costs Sh.3.8 million and has an estimated lifespan of 4
years. Project Beta costs Sh.8 million with an estimated lifespan of 6 years. Both projects have a
zero-salvage value. An investment in working capital of Sh.825,000 will be required irrespective
of the project to be undertaken. The cost of capital for the company is 12%. The corporate tax
rate is 30%.

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Required: Using the discounted payback period method, recommend to the management of
Bundacho Limited on which project to undertake. (8 marks)

(c) The earnings per share (EPS) and dividend per share (DPS) data for Maraba Ltd. over the last
five years are provided below:
Year Dividend per share (DPS) Earnings per share (EPS)
(Sh.) (Sh.)
2013 1.00 2.50
2014 1.10 2.70
2015 1.20 3.00
2016 1.50 3.20
2017 1.80 3.50
Additional information: A prospective investor is considering buying the shares of this company
which are currently selling at Sh.55 each at the securities exchange. The investor’s required rate
of return is 20%.

Required: Advise the investor on whether to buy the shares of Maraba Ltd. using Gordon’s
model. (8 marks) (Total: 20 marks)

QUESTION THREE
(a) Propose four factors that might lead to soft capital rationing in a limited company. (4 marks)

(b) Explain four roles that are played insurance companies in the financial market of your
country. (4 marks)

(c) Bemunyonge Ltd. has just paid a dividend of Sh.4 per share. The company expects that the
dividend will grow at the rate of 20% per annum for the first two years, then grow at the rate of
10% per annum for the next 2 years and thereafter grow at the rate of 6% per annum into
perpetuity. The required rate of return for the company is 16%.

Required: The theoretical value of the company’s share. (4 marks)

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(d) Bahati Enterprises is considering amendments to its current credit policy. The firm’s current
annual credit sales amount to Sh.6,000,000. The current credit terms are net 30 with an average
debtors’ collection period of45 days.
The following information relates to the proposed credit policy: The credit period to be extended
to net 60. Annual sales are expected to increase 20%. Bad debts are expected to increase from
2% to 2.5% of the annual credit sales. Credit analysis and debt collection costs are expected to
increase Sh.84,000 per annum. The return on investment in debtors is 12%. For every Sh.100 of
sales, Sh.75 is the variable cost. Assume one year has 360 days.

Required: Advise the management of Bahati Enterprises on whether to adopt the proposed
credit policy. (8 marks) (Total: 20 marks)

QUESTION FOUR
(a) The following are the financial statements for ABC Ltd. and X YZ Ltd. for the year
ended 30 September 2018:
Income statement for the year ended 30 September 2018:
ABC Ltd. XYZ Ltd.

Sh.“million” Sh.“million’
Revenues 4,000` 6,000
Cost of sales (3,000) (4,800)
Gross profit 1,000 1,200
Expenses:
Distribution costs 200 150
Administration expenses 290 250
Finance costs 10 (500) 400 (800)
Profit before tax 500 400
Tax paid (120) (90)
Profit after tax 380 310
Dividends paid (150) (100)

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 Retained profits for the year 230 210
Retained profit brought forward 220 2,480
Retained profit carried forward 450 2,690

Statement of financial position as at 30 September 2018:

ABC Ltd. XYZ Ltd.
Sh. “million” Sh. “million’
Non-current assets:
Land and buildings 1,200 5,000
Furniture and motor vehicles 600 1,000
1,800 6,000
Current assets:
Inventories 400 800
Trade receivables 850 750
Financial assets 100 230
Cash at bank – 1,350
100 1,880
3,150 7,880
Financed by:
Equity and liabilities:
Ordinary share capital 1,000 1,600
Retained profits 450 2,690
1,450 4,290
Non-current liabilities:
Bank loan 500 3,000
Current liabilities:
Trade payables 1,080 590
Bank overdraft 120 1,200
– 590
3,150 7,880
Required:

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(i) Vertical common size statements of income for the year ended 30 September 2018. (6 marks)
(ii) Vertical common size statements of financial position as at 30 September 2018. (6 marks)
(b) New Ways Ltd. intends to raise new capital to expand its production level. The company
plans to undertake the following financial decisions:
Issue 200,000 ordinary shares which have a par value of Sh.10 at Sh.16 per share. The
floatation cost per share is Sh. 1.
Issue 75,000, 12% preference shares which have a par value of Sh.20 at Sh.18 per share. The
total floatation cost is Sh. 150,000.
Issue 50,000, 18% debentures which have a par value of Sh. 100 at Sh.80 per debenture.
Borrow Sh. 5,000.000. 18% long-term loan. The total floatation cost is Sh.200,000.
Additional information: The company paid 28% ordinary dividends which is expected to
grow at the rate of 4% per annum. The corporate tax rate is 30%.
Required:
(i) The total capital to be raised net of floatation costs. (2 marks)
(ii) The weighted marginal cost of capital (WMCC) for the company. (6 marks) (Total: 20
marks)

QUESTION FIVE
(a) Highlight four circumstances under which investors might find it suitable to use an Islamic
equity fund. (4 marks)
(b) William Mgunya intends to invest Sh.200,000 in a redeemable 12%, Sh.100 debentures for 3
years. The current market value of the debentures is Sh.80 per debenture. The required rate of
return on the debentures is 10% per annum.

Required;
Advise William Mgunya on whether to invest in the debentures. (4 marks)

(c) Daima Investment Bank has provided the following information relating to two of its
securities namely; A and B:
State of economy Probability (P;) Security returns (%)
A B

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Stable 0.30 12 6
Expansion 0.40 15 7.5
Recession 0.30 10 5
Required:
(i) The expected return for each security. (2 marks)
(ii) The standard deviation for each security. (2 marks)
(iii) The correlation coefficient between the two securities’ returns. (3 marks)
(iv) Determine the expected return of a portfolio constituting 60% of Security A and 40%
of Security B. (2 marks)
(v) Compute the risk of the portfolio in (c) (iv) above. (3 marks)(Total: 20 marks)

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