Valuation of Securities
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.