IAPM KMBN FM 01

Unit 4
 Share Valuation Model
• The valuation model used to estimate the intrinsic value of a share is the
present value model.

• The intrinsic value of a share is the present value of all future amounts to
be received in respect of the ownership of that share.

• The major receipts that come from the ownership of a share are the
annual dividends and the sale proceeds of the share at the end of the
holding period. These are to be discounted to find their present value,
using a discounted rate that is the rate of return required by the investor,
taken into consideration the risk involved

• Thus, the intrinsic value of a share is the present value of all the future
benefits expected to be received from that share.

Buy - IV > MV
Sell - IV < MV
 1. One Year Holding Period
• It is easy to start share valuation with one year
holding period assumption.
• Here an investor intends to purchase a share now,
hold it for one year and sell it off at the end of
one year.
• In this case, the investor would be expected to
receive an amount of dividend as well as the
selling price after one year.
• The present value of the share may be expressed
as:
 QUESTION
An investor expects to get Rs. 3.50 as dividend
from a share next year and hopes to sell off the
share at Rs. 45 after holding it for 1 year. If his
required rate of return is 25%, calculate the
present value of the share, to take decision.
 2. Multiple Year Holding Period
• An investor may hold a share for a certain
numbers of years and sell it off at the end of
his holding period. In this case he would
receive annual dividends each year and the
sale price per share at the end of the holding
period
• The present value of the share may be
expressed as:
 QUESTION
• If an investor expects to get Rs. 3.5, Rs. 4, Rs.
4.5 as dividend from a share during the next
three years and hopes to sell it off at Rs. 75 at
the end of the third year and if his required
rate of return is 25%, what is the intrinsic
value to take a decision?
 3.Constant Growth Model
• In this model it is assumed that dividends will
grow at the same rate (g).
• Known as Gordon's share valuation model named
after the model’s originator, Myron J. Gordon.
• This is one of the most well known and widely
used models because of its simplicity.
• The model does not require forecast of future
dividend and future selling price of the share.
• All that the model requires is a dividend growth
rate assumption and a discount rate.
 Question
• A company has declared a dividend of Rs. 2.5
per share for the current year. The company
has been following a policy of enhancing its
dividends by 10% every year and is expected
to continue this policy in the future also. An
investor who is considering the purchase of
shares of this company has required rate of
return of 15%.
 4. Multiple Growth Model
• The constant growth assumption may not be realistic in many
situations. The growth in dividends may be at varying rates.
• A typical situation for many companies may be that a period of
extraordinary growth will prevail for a certain number of years,
after which growth will change to a level at which it is expected to
continue indefinitely.
• This situation can be represented by a two stage growth model.

• In this model future time period is viewed as divisible into two

different growth segments, the initial extraordinary growth period
and subsequent constant growth period.

• During the initial period growth rates will be variable from year to
year, while during the subsequent period the growth rate will
remain constant from year to year.
 QUESTION
A company paid a dividend of Rs. 1.75 per share
during the last year. It is expected to pay a
dividend of Rs. 2 per share during the next year.
Investors forecast a dividend of Rs. 3 and Rs. 3.5
per share respectively during the two
subsequent years. After that it is expected that
annual dividends will grow at 10% per year into
indefinite future. Expected rate of return is 20%.
What will be the intrinsic value?
V1- 5.78
V2- 22.28 Intrinsic value- 28.06
 What is the 'Earnings Multiplier'

The earnings multiplier, also called the price-to-earnings ratio (P/E), is

a valuation method used to compare a company's current share price
to its per-share earnings.

The earnings multiplier frames a company's current stock price in

terms of the company's earnings per share (EPS) of stock.

It presents the stock's market value as a function of the company's

earnings and is computed as (price per share/earnings per share).

It is also known as the price-to-earnings (P/E) ratio. It can be used as a

simplified valuation tool for comparing relative costliness of the stocks
of similar companies, and for judging current stock prices against their
historical prices on an earnings relative basis.
 Significance

- The earnings multiplier can be a useful tool for determining how expensive the
current price of a stock is relative to the company's earnings per share of stock.

- This is an important relationship because the price of a stock is supposed to be a

function of the anticipated future value of the issuing company and future cash
flows resulting from ownership of that stock.

- If the price of a stock is historically expensive relative to the company's earnings, it

could potentially indicate that it is not a good time to buy the stock because the
stock is expensive.

- In addition, comparing earnings multipliers across similar companies can help rate
how expensive the companies' stock prices are relative to each other
 What is 'Price-To-Book Ratio - P/B Ratio'
Companies use the price-to-book ratio to compare
a firm's market to book value by dividing price per
share by book value per share. Some people know
it as the price-equity ratio.

We can calculate this as:

P/B ratio = market price per share / book value per
share

In this equation, book value per share = (total

assets - total liabilities) / number of shares
outstanding
 Significance
- A lower P/B ratio could mean the stock
is undervalued. However, it could also mean
something is fundamentally wrong with the company.
As with most ratios, this varies by industry.
- This ratio also indicates whether you're paying too
much for what would remain if the company went
bankrupt immediately.
- The P/B ratio reflects the value that market
participants attach to a company's equity relative to
its book value of equity. A stock's market value is a
forward-looking metric that reflects a company's
future cash flows.
 Price-To-Sales Ratio - PSR
- The price-to-sales ratio is a valuation ratio that compares a company’s
stock price to its revenues.

- It can be calculated either by dividing the company’s market

capitalization by its total sales over a 12-month period, or on a per-share
basis by dividing the stock price by sales per share for a 12-month period.

- Abbreviated as the P/S ratio or PSR, the price-to-sales ratio is also known
as a “sales multiple” or “revenue multiple.”

- The 12-month period used for sales in the price-to-sales ratio is generally
the past four quarters (also called trailing 12 months or ttm), or the most
recent or current fiscal year. A price-to-sales ratio that is based on forecast
sales for the current year is called a forward ratio.

- Like all ratios, the price-to-sales ratio is most relevant when used to
compare companies in the same sector. A low ratio may indicate possible
undervaluation, while a ratio that is significantly above the average may
suggest overvaluation.
 Economic Value Added - EVA
- Economic value added (EVA) is a measure of a company's financial
performance based on the residual wealth calculated by deducting its cost
of capital from its operating profit, adjusted for taxes on a cash basis.

- EVA can also be referred to as economic profit, as it attempts to capture the

true economic profit of a company.

- This measure was devised by management consulting firm Stern Value

Management, originally incorporated as Stern Stewart and Co.

- If a company's EVA is negative, it means the company is not generating

value from the funds invested into the business. Conversely, a positive EVA
shows a company is producing value from the funds invested in it.

- The formula for calculating EVA is:

Net Operating Profit After Taxes (NOPAT) - Invested Capital * Weighted

Average Cost of Capital (WACC)
 Benefits and Drawbacks of EVA
- EVA assesses the performance of a company and its management
through the idea that a business is only profitable when it creates
wealth and returns for shareholders, thus requiring performance
above a company's cost of capital.

- EVA as a performance indicator is very useful. The calculation shows

how and where a company created wealth, through the inclusion
of balance sheet items. This forces managers to be aware of assets
and expenses when making managerial decisions.

- However, the EVA calculation relies heavily on the amount

of invested capital, and is best used for asset-rich companies that
are stable or mature. Companies with intangible assets, such as
technology businesses, may not be good candidates for an EVA
evaluation.
 What is intrinsic value and market value ?
Intrinsic value is a way of describing the perceived or true value of an asset.
This is not always identical to the current market price because assets can be
over- or undervalued. Intrinsic value is a common part of fundamental
analysis, which investors use to assess stocks, as well being used in options
pricing.

The intrinsic value of a share is the present value of all future amounts to be
received in respect of the ownership of that share.

In share trading
In share trading, intrinsic value can refer to the 'true' value of a company as
perceived by a trader or investor. Different traders will have different ideas of
what constitutes intrinsic value for a stock, with some giving prominence to
strong fundamentals and others looking at its potential for growth.
In share trading, intrinsic value measures the inherent value of a share, while
extrinsic value measures how much of its worth is derived from external
factors.

Market Value
The market value per share or fair market value of a stock is the price that
a stock can be readily bought or sold in the current market place. In other
words, the market value per share is the “going price” of a share of stock.
 Valuation of Debentures
For the purpose of valuation, debentures can be
classified as:
- Redeemable
- Non- Redeemable/ perpetual
- Convertible
- Deep discount/ Zero Coupon Bonds
 V= I x PV + M x PVF
V= Value of the debenture
I = Interest amount per annum
M = Maturity value of the debenture
r = required rate of return
PV= present value
PVF = Present value factor

Buy – IV > MV
Sell – IV< MV

Ques. A 9% Rs. 100 face value debenture having a provision for redemption at
a premium of 5% at the end of 5 years is being traded in the market from the
very first day of the issue. An investor has expected rate of return 15%, suggest
him at what price he should buy the debenture? (Rs. 82.36)

Ques. 8% Rs. 200 debenture is being issued by the company at a discount of

2.5%. This has a provision for redemption at a premium of 5% at the end of 7th
year. An investor has expected rate of return of 7%, suggest him should he but
it or not. (Rs. 216.86, Buy)
Ques. 12.5%, Rs. 100 debenture is available in the market at Rs. 115.
These have a provision for redemption in three instalments, starting
from the end of 4th year till 6th year. Rs.40, Rs. 40 and Rs. 20 to be paid
respectively at the end of fourth, fifth and sixth year. An investor has
expected rate of return of 10%. Suggest him should he buy it or not.
(Rs.109.071 do not buy)

Year amount at the end of each year Present Value Factor

1 12.5 .909 x 12.5 = 11.362

2 12.5 .826 x 12.5 = 10.325
3 12.5 .751 x 12.5 = 9.387
4 40 +12.5 = 52.5 .683 x 52.5 = 35. 857
5 40+ 7.5 = 47.5 .620 x 47.5 = 29.45
6 20 + 2.5 = 22.5 .564 x 22.5 = 12.69
V = 11.362+ 10.325+9.387+ 35.
857+ 29.45 + 12.69 = 109.071
 Valuation of Deep discount
debentures/ bonds
V = M x PVF
A deep discount bond of face value Rs. 10,000 is
being issued at a discount of 50% to face value; it
has a provision for redemption at par at the end of
sixth year. If an investor has required rate of return
9% per annum, then suggest him at what price
should he buy it. (Rs. 5960, purchase
recommended) V = 10,000 X 0.596
Issue value = Rs. 5000
Intrinsic Value = Rs. 5960
 Valuation of Perpetual Debenture
V = I x 100
R
A company has issued debenture with interest rate
of 12% per annum at Rs. 120. Face value of these is
Rs. 100, and these are non redeemable. An investor,
whose expected rate of return is 11% per annum,
should he purchase it. If these are available in the
market at Rs. 102, then what will be your decision.

(Rs. 109.09)
 Valuation of Convertible Debentures
V = I x PV + MV x PVF
9 x 3.35 + (32x4) x 0.497
MV = market value

A 9% Rs. 100 face value debenture having a provision for

conversion at the end of 5 years into 4 equity shares of
face value Rs. 10 each at the premium of Rs. 15 each. It is
expected that the equity share will have market value of
Rs. 32 per share on the date of conversion. An investor
has expected rate of return 15 % pa. suggest him at what
price, he should be ready to buy the debenture?
(Rs. 93.76, don’t buy)
 Holding period return
HPR = gain/loss + coupon interest payment
price at the beginning of the holding period

Ques. An investor A purchased a bond at a price of

Rs. 900 with Rs. 100 as coupon payment and sold it
at Rs. 1000, what is the holding period return if the
bond is sold at Rs. 750 after receiving Rs. 100 as
coupon payment, what is the HPR.
(22.22% and 5.5 %)
 The current yield
it is the rate of return, which an investor can expect to earn if the
bond is held till maturity.
YTM= Coupon Interest Payment+ (M-P) /n
0.4M + 0.6P
M = redeem price
P = market price

Ques. A four year bond with 7% coupon rate and maturity value of
Rs. 1000 is currently selling at Rs. 905. what is its yield to maturity?
(9.94%)

Ques. A Rs. 100 par value bond bearing a coupon rate of 11%
matures after 5 years the expected yield to maturity is 15% present
market is Rs. 82. should investor buy the debenture.(86.55, buy)
I x PV + M x PVF 11 x 3.35 + 100 x .497
 Duration
- It is the discounted time weighted cash flow of
the debt security divided by its price at a given
yield.
- It represents the average time period taken
for the recovery of invested funds with the
help of cash flow generated by the bond.
- Duration is used to assess comparative level of
risk.
- Bonds having longer duration represent high
risk as compared to the ones having shorter
duration
Formula
 General rules for duration
1. Larger the coupon rate, lower the duration and less
volatile the bond price.
2. Longer the term of maturity, longer the duration and
more volatile the bond.
3. Higher the yield to maturity lower the bond duration and
bond volatility and vice versa.
4. In a zero coupon bond, the bonds term to maturity and
duration are the same. The zero coupon bond makes only
one balloon payment to repay the principle and interest
on the maturity date.

Ques. Calculate the duration for Bond A & Bond B with 7% &
8% coupons having maturity period of 4 years. The face value
is Rs. 1000. Both the bonds are currently yielding 6%.
 Calculation of Duration for Bond A with 7% coupon rate

Ye Cash flow (Ct ) 1 PV x CT Ct Ct

ar (1+r)t (1+r)t (1+r)t x t
6% Po Po

1 1000x 7%= 70 0.943 70 x .943 = 66.01 66.01/ 1034.34 =0 .0638 0.0638 x 1 = .0638

2 70 0.890 70 x .890 = 62.30 62.30/ 1034.34 =0 .0602 0 .0602 x 2 = 0.1204

3 70 0.839 70 x .837 = 58.59 58.59/1034.34 = 0. 0566 0. 0566 x 3 = 0.1698

4 1000+70= 1070 0.792 1070 x .792= 847.44 847.44/1034.34 =0.8193 0.8193 x 4 = 3.2772

Po = 1034.34 D = 3.6312
 Calculation of Duration for Bond B with 7% coupon rate

Year Cash flow (Ct ) 1 PV x CT Ct Ct

(1+r)t (1+r)t (1+r)t x t
Po Po

1 80 0.943 75.44 0.0705 .0705

2 80 0.890 71.20 0.0667 0. 1334
3 80 0.839 67.12 0.0626 0. 1878
4 1080 0.792 855.36 0.8001 3.2004
Po = 1069.12 D = 3.5921
 Interpretation
Bond A Bond B
Coupon rate 7% 8%
Face value 1000 1000
Years to maturity 4.0 4.0
Macaulay's duration 3.631 years 3.592 years

From the above it is clear that the bond with larger coupon payments has a shorter
duration compared to the bond with low coupon rate.
 Bond Value Theorems
Theorem 1
If the market price of the bond increases, the yield would decline and vice versa.
- Even though the bonds are of the same maturity and coupon rate, the difference in the
market price leads to difference in yield. The bond with low price has higher yield because
with lesser amount of money more return is earned.

Theorem 2
- If the bond’s yield remains the same over its life, the discount or premium depends on
the maturity period
- This means, the bond with a short term to maturity sells at a lower discount than the
bond with long term to maturity.

Theorem 3
If a bond’s yield remains constant over its life, the discount or premium amount will decrease
at an increasing rate as its life gets shorter.

Theorem 4
A raise in the bond’s price for a decline in the bonds yield is greater than the fall in the bond’s
price for a raise in the yield.

Theorem 5
The change in the price will be lesser for a percentage change in bond’s yield if its coupon
rate is higher.
 The term Structure of interest Rates (Yield Curve)

Yield to maturity (YTM) is the total return anticipated on a bond if the bond is held
until it matures. ... In other words, it is the internal rate of return (IRR) of an
investment in a bond if the investor holds the bond until maturity, with all payments
made as scheduled and reinvested at the same rate.

The bond portfolio manager is often concerned with two aspects of interest
rates – the interest rate level and the term structure of interest rates.
The relationship between the yield and time or years to maturity is called the
term structure.
The term structure is also known as yield curve.
- In analysing the effect of maturity on yield and all other influences are held
constant.
- The selected bonds should not have early redemption features.
- The maturity dates are different, but risks, tax liabilities, and redemption
possibilities are similar.
 the general perception is that the Curve will be

upward moving upto point and then become flat.

There are at least three competing theories that attempt

to explain the term structure of interest rates.
- Expectation Theory
- Liquidity Preference Theory
- Preferred Habitat or segment theory
 Expectation Theory
- Developed by J R Hicks (1939), F Lutz(1940) and B Malkiel (1966).
- According to this theory, the shape of the curve can be explained by
the expectations of investors about the future interest rates.
- If the short term rates are expected to be relatively low in the
future, then the long term rate will be below the short term rate.

There are three reasons for investors to anticipate a fall in the interest
rate.
1. Anticipation of the fall in the inflation rate and reduction in the
inflation premium.
2. anticipation of a balanced budget or cut in fiscal deficit
3. Anticipation of recession in the economy, and a fall in the
demand for funds by private companies.

The long term rates will exceed the current short term rates, if there is
an expectation that the market rates will be higher in the future. Thus
the yield curve depends upon the expectations of the investors.
 Liquidity Preference Theory
▪ Keynes’ liquidity preference theory as advocated by J R Hicks (1939) accepts that
expectations influence the shape of the yield curve.

▪ In the world of uncertainty, it would be more desirable for investors to invest in short term
bonds than in long term ones because of their liquidity.

▪ If no premium exists for holding long term instruments, investors would prefer to hold short
term bonds to minimize the possible variation in the nominal value of their portfolio.

▪ The exponents of the liquidity preference theory believe that the investors prefer the short
term rather than the long term.

▪ Hence, they have to be motivated to buy the long term bonds or lengthen the investment
horizon.

▪ The bond issuing corporation or contributor pays premium to motivate the investors to buy.

▪ This liquidity premium theory asserts that over time the forward rates are actually higher
than the projected interest rates.
 Segmentation theory
- The liquidity preference cannot be the main consideration for all classes of investors.
- Insurance companies, pension funds, and even retired persons prefer long term rather
than short term securities to avoid possible fluctuations in the interest rate.
- For example:
Life insurance companies offer insurance policies that do not require payment for a long
time.
For example, an insurance policy issued to a 25 year old may involve another 20 or more
years before the company has to make payment. Premium payments are fixed by the
expected future rate of interest. If the insurance companies invest the funds in a long term
bond, the interest the bond would earn is certain and if the earned interest rate is higher
than promised interest rate, the company stands to gain, and its risk is also reduced.
If it invests in one year bonds, risk of re investment is there and if there is a fall in the market
interest rate, the insurance company stand to lose, and it would be difficult for the company
to meet its obligation. This leads for the insurance companies to prefer long term bonds over
short term bonds.

On the other hand, commercial banks and corporates may prefer liquidity to meet their short
term requirements, and therefore, they prefer short term issues.

The supply of and demand for funds are segmented in sub markets because of the preferred
habit of individuals. Thus, the yield is determined by the demand for and supply of funds.