VALUATION OF BONDS

AND STOCKS
 CONCEPTS OF VALUE

• Liquidation Value

• Going Concern Value

• Book Value

• Market Value

• Intrinsic Value
 BASIC VALUATION MODEL
The value of any asset, real or financial, is equal to the
present value of the cash flows expected from it.

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

V0 = value of the 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 the asset
 EXAMPLE
Year Cash flow
1 20
2 30
3 220
Discount rate = 16 percent
V0 = 20 x PV16%,1 + 30 x PV16%,2 + 220 x PV16%,3
V0 = 20 x 0.862 + 30 x 0.763 + 220 x 0.641
= 180.55
KEY INPUTS
 Cash Flows
 Timing
 Discount Rate
 Par value
 Coupon rate
 Maturity
 Redemption value
 Market value
 Types of bonds-

Zero coupon,perpetual,fixed maturity bonds

 BASIC BOND VALUATION MODEL
n I F
V= +
t =1 (1+k d)t (1+k d)n

=
I x PVAkd,n + F x PVkd,n

Example
Rs.100 par .. 12 percent coupon
8 years maturity … Required return 14 percent

V = Rs.12 x PVA14%,8 + Rs.100 x PV14%,8

= Rs.12 x 4.639 + Rs.100 x 0.351

= Rs. 90.77
 Pure discount bonds are called deep-
discount bonds or zero-interest bonds or
zero-coupon bonds.
 The market interest rate, also called the
market yield, is used as the discount rate.
 Value of a pure discount bond = PV of the
amount on maturity:
 The longer the maturity of a bond, the
higher will be its sensitivity to the
interest rate changes. Similarly, the price
of a bond with low coupon rate will be
more sensitive to the interest rate
changes.
 However, the bond’s price sensitivity can
be more accurately estimated by its
duration. A bond’s duration is measured
as the weighted average of times to each
cash flow (interest payment or repayment
of principal).
 The value of the preference share would be
the sum of the present values of dividends
and the redemption value.
 A formula similar to the valuation of bond

can be used to value preference shares

with a maturity period.
S u p p o s e a n in v e s t o r is c o n s id e r in g t h e p u r c h a s e o f a 1 2 -y e a r , 1 0 % R s 1 0 0 p a r v a lu e p r e f e r e n c e s h a r e . T h e
r e d e m p tio n v a lu e o f th e p r e fe r e n c e s h a r e o n m a tu r ity is R s 1 2 0 . T h e in v e s to r ’s r e q u ir e d r a t e o f r e t u r n is
1 0 .5 p e r c e n t . W h a t s h o u ld s h e b e w illin g t o p a y f o r t h e s h a r e n o w ? T h e in v e s t o r w o u ld e x p e c t t o r e c e iv e
R s 1 0 a s p r e f e r e n c e d iv id e n d e a c h y e a r f o r 1 2 y e a r s a n d R s 1 1 0 o n m a t u r it y (i.e ., a t t h e e n d o f 1 2 y e a r s ) .
W e c a n u s e t h e p r e s e n t v a lu e a n n u ity f a c to r to v a lu e th e c o n s ta n t s tr e a m o f p r e fe r e n c e d iv id e n d s a n d th e
p r e s e n t v a lu e fa c to r to v a lu e t h e r e d e m p tio n p a y m e n t.
 1 1  120
P 0  10     
 0 . 105 0 . 105  ( 1 . 105 ) 12  ( 1 . 105 )
12

 10  6 . 506  120  0 . 302  65 . 06  36 . 24  Rs 101 . 30

N o t e t h a t t h e p r e s e n t v a lu e o f R s 1 0 1 .3 0 is a c o m p o s it e o f t h e p r e s e n t v a lu e o f d iv id e n d s , R s 6 5 .0 6 a n d
t h e p r e s e n t v a lu e o f t h e r e d e m p t io n v a lu e , R s 3 6 .2 4 .T h e R s 1 0 0 p r e f e r e n c e s h a r e is w o r t h R s 1 0 1 .3 t o d a y
a t 1 0 .5 p e r c e n t r e q u ir e d r a t e o f r e t u r n . T h e in v e s t o r w o u ld b e b e t t e r o f f b y p u r c h a s in g t h e s h a r e f o r R s 1 0 0
to d a y .
 The valuation of ordinary or equity shares
is relatively more difficult.
◦ The rate of dividend on equity shares is
not known; also, the payment of equity
dividend is discretionary.
◦ The earnings and dividends on equity
shares are generally expected to grow,
unlike the interest on bonds and
preference dividend.
 The Dividend capitalisation model

 The corporate valuation model

 The P/E multiple approach

 The EVA approach

 The value of an equity share is determined
by capitalising the future cash inflows i.e.
expected from the equity investment at the
opportunity cost of capital representing
the risk associated .
 Single period valuation:

Po = D1 + P1
(1+ke) (1+ke)
 Multi Period valuation-
 Constant dividend
Po = D/Ke
 e.g. The value of an equity share with
constant dividend of Rs.30 per share and
equity capitalisation rate of 15 % would be
Rs.200.
 Growing dividends:
 Dividend expected for the year n is given by
D(1+g)n

 Capitalising the expected dividend growing at

a constant rate ‘g’ the valuation will be:
Po = D1/(ke-g)
 For multi stage growth with super normal and
normal growth the valuation is:
Po =
PV of dividends during supernormal growth
period +
PV of dividends during infinite
normal growth period
 The share of a company paid a dividend of
Rs. 20 in the last year.The dividend is
expected to grow at a constant rate of 8% per
year in the future.The required rate of return
of this stock is considered to be
12 %.How much should the stock sell for
now?
What price the stock should sell 2 years from
now?
 A company’s earnings and dividends have
been growing at a rate of 18 % p.a.This
growth rate is expected to continue for 4
years.After that the growht rate will fall to 12
% for the next 4 years.Thereafter the growth
rate will fall to be 6 % forever.If the last
dividend per share was Rs.2 and the equity
investors required rate of return is 15 % ,what
is the intrinsic value per share?
 Estimation errors 

 Unsustainable high current growth 

 Errors in forecasting dividends 

Intrinsic value of equity =
Corporate value – (market value of debt and
preference share capital )

 Where Corporate value = PV of expected

future free cash flows
 Calculate value of equity shares on
31/3/2017.Following details are available:
 Expected operating income for year 17-18

:Rs.500L
 Depreciation expenses for 17-18 :Rs.100L
 Effective tax rate :30 %
 The expected capital expenditure :Rs.200L
 Additional working capital required Rs.50L
 The FCFs are expected to grow at a constant

rate of 6 % p.a.
 Cost of equity 14 % and WACC is 10 %
 The market value of company’s debt is 2,000L
 20 Lacs of equity stock is outstanding
 The value of an asset is compared to the
values assessed by the market for similar or
comparable assets.
 Since the absolute prices cannot be compared

standardizing process is required to create

price multiples.
 The standardized value or multiple for the

asset being analyzed is compared to the

standardized values for comparable asset,
controlling for any differences between
the firms that might affect the multiple, to
judge whether the asset is under or over
valued
 Define the multiple

 Describe the multiple

 Analyze the multiple

 Apply the multiple

 Relative valuation is much more likely to reflect
market perceptions and
moods than discounted cash flow valuation.
 Useful when price needs to reflect market

perceptions e.g.:
 the objective is to sell a security at that price

today (as in the case of an IPO)

 investing on “momentum” based strategies

 With relative valuation, there will always be a

significant proportion of
securities that are under valued and over
valued.

 Since portfolio managers are judged based
upon how they perform on a
relative basis (to the market and other money
managers), relative valuation is
more tailored to their needs
 Relative valuation generally requires less

information than discounted cash

flow valuation (especially when multiples are
used as screens)
 P/E = Market Price per Share / Earnings per Share
 Price: is usually the current price

is sometimes the average price for the year

 EPS: earnings per share :

 In most recent financial year

 Earnings per share in trailing 12 months (Trailing

PE)
 Forecasted earnings per share next year (Forward

PE) /future years

 Approach commonly used by investment
analysts to estimate the intrinsic value using
price-earning multiple.

 Steps involved:
1. Estimate the earning per share
2. Establish a Price-earnings multiple
3. Develop a value range
 The P/E ratio is derived as :
(1-b)
ke – (ROE x b)
Where:
 (1-b) is the dividend payout ratio
 Ke is the cost of equity
 (ROE x b) is the expected growth rate
 Riskier the stock higher is the Ke and hence
lower is the P/E multiple
 The enterprise value to EBITDA multiple is
obtained by netting cash out
against debt to arrive at enterprise value and
dividing by EBITDA.
Enterprise Value =
EBITDA
(Market Value of Equity + Market Value of Debt – Cash)
EBITDA
 EBITDA( EV/EB
Firm EPS L) M.P. EV P/E TDA
A 10 150 200 1800
B 8 100 120 1500
C 15 200 330 2800
             
AVG.         19 14
 The current dividend on an equity share of Omega
Limited is Rs.8.00 on an earnings per share of Rs.
30.00. (i) Assume that the dividend per share will
grow at the rate of 20 percent per year for the next
5 years. Thereafter, the growth rate is expected to
fall and stabilise at 12 percent. Investors require a
return of 15 percent from Omega’s equity shares.
What is the intrinsic value of Omega’s equity share?

 (Ans. 415.02)