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Topic 1_Valuation Theory

The document discusses the valuation of shares and debentures from an investor's perspective, emphasizing the principles of time value of money and risk-return relationship. It outlines the types of financial assets, including ordinary shares, debentures, and preference shares, and explains the importance of cash flows, timing, and discount rates in valuation. The basic valuation model involves estimating cash flows, determining the required rate of return, and discounting these cash flows to find their present value.

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5 views7 pages

Topic 1_Valuation Theory

The document discusses the valuation of shares and debentures from an investor's perspective, emphasizing the principles of time value of money and risk-return relationship. It outlines the types of financial assets, including ordinary shares, debentures, and preference shares, and explains the importance of cash flows, timing, and discount rates in valuation. The basic valuation model involves estimating cash flows, determining the required rate of return, and discounting these cash flows to find their present value.

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mhambinamhla
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We take content rights seriously. If you suspect this is your content, claim it here.
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You are on page 1/ 7

VALUATION OF SHARES AND DEBENTURES

Refer to your textbook chapter 8, pg. 164 – 180 Financial


Management is South Africa, 3rd Edition, J Marx, C de Swardt, M
Beaumont Smith, P Erasmus.

1. INTRODUCTION

NB: Please ensure that you know the key terms in the table at the
start of the chapter.

In this chapter we are concerned about price or value from the investor’s
point of view.

Valuation is based on 2 fundamental principles of FM:


1. Time value of money – features in most valuation models. Most
basic valuation model calculates the sum of the present value of all
net cash inflows expected for the duration of the investment.

2. Risk-return principles – investors expect a higher return for a


risky investment. Thus, the discount rate is determined by the risk
and return associated with an asset.

In this chapter we will look at the valuation of 2 types of financial


assets/investments:
1. Ordinary shares
2. Debentures
3. Preference shares
2. IMPORTANT POINTS BEFORE WE START:
A. To raise funds for the purchase of investments/assets, a
public company can sell the following to investors:

Equity (Ownership), this means that the company sells ordinary


shares to investors and the investors become ordinary
shareholders in the company. The company receives the money
for the shares and the shareholders expect to receive a dividend.
Remember it is not compulsory for a company to issue ordinary
shareholders a dividend.

Debt, this means that the company sells debentures (also known
as bonds) to the investors. The company receives the money for
the debentures and the debenture holder (individual who bought
the debenture) receives annual/bi-annual interest payments every
year. In addition to the interest payments the company must pay
the debenture holder the par value of the debenture, when the
debenture matures (expires). For this reason, a debenture is
regarded as the company taking out a loan (debt), as the company
must pay interest and the par value (principle) to the debenture
holder.

Preference shares are a hybrid between equity and debt. The


preference share holder is entitled to a dividend (unlike the
ordinary shareholder), that is, it is compulsory for the company to
issue preference shareholders with a dividend. However, the
preference shareholders dividend is fixed, that is the dividend
remains the same amount and does not change like ordinary
dividends.
B. Remember the following:
• When we are valuing an ordinary share, debenture or
preference share we are valuing it from the perspective of
the investor, that is, the person who bought the ordinary
share, debenture or preference share.
• Valuation is a process of taking future cash flows and
discounting them to the present. So, for each of these
instruments, we are simply determining the future cash flows
and then discounting these future cash flows to the present.
• To calculate the present value of the future cash flows, we
ALWAYS use the required rate of return as the discount rate.
• What is the required rate of return (RROR)? This is the
rate of return that the investor expects to get from an
investment. In other words, it is what the investor would like
to receive from the investment.
• What is the coupon rate? This is the rate of return that the
investment gives the investor.
• If the coupon rate = the required rate of return, that means
that the investor is happy, because the investment is giving
the investor what they want.
• To calculate the interest in Rands of a debenture, take
coupon rate x par value.
3. VALUE DEFINED
Various types of value exist:
a. Par Value
Also known, face value. Is the value at which the asset is issued
into the primary market. Eg. Vodacom group issued ordinary
shares at 1cents each in May 2008.
(Definition of primary market: Where a newly issued security is
first offered. All subsequent trading occurs on the secondary
market.)

b. Market Value
The value an asset assumes once it trades in the market as
determined by supply and demand.

c. Economic Value
Also known as the intrinsic value, is the present value of all the
future cash flows the investor expects to get from the investment in
a specified time period. This is the value in the eyes of the
investor.
NB: If the intrinsic value of an asset is greater than the market
value, the asset is undervalued in the market. (priced below its
value). This is a good time for the investor to buy the asset, as it is
selling at a bargain.
If the intrinsic value of an asset is less than the market value, the
asset is over-valued in the market (priced above its value). This is
a good time to sell your asset, as buyers are willing to pay more
than what you, the investor, think the asset is worth.
4. KEY INPUTS TO VALUATION (what you need to perform a
valuation of an asset)
a. Cash flows
Value of an asset depends on the cash flow (return) we can expect
it to generate during a specified period.

b. Timing
Due to time value of money and risk involved in investment, we
prefer to receive cash flow earlier rather than later.

c. Discount rate
The discount rate reflects the risk – return relationship of the asset.
Risk describes the chance that an expected outcome will not
occur.

In general:
An asset with high risk Investor expects a higher rate of
return.
An asset with low risk Investor expects a lower rate of
return.
When you value an investment, use your required rate of
return as the discount rate to find the present value of the
future cash flows.

Thus:
• If your discount rate (RROR) is high, the present value (PV)
of investment will be low.
• If your discount rate (RROR) is low, the PV of investment will
be high.
For example:
Scenario A: (High discount rate)
You expect to receive R1 000 in 7 years from an investment, that offers
15% per annum interest. What is the present value of your investment?

PV = FV x PVIF7;15% (table A-3)


= 1 000 x 0.3759
= R 375.90 (higher discount rate, 15%, lower PV)
Scenario B: (Lower discount rate)
You expect to receive R1 000 in 7 years from an investment, that offers
10% per annum interest. What is the present value of your investment?

PV = FV x PVIF7;10% (table A-3)


= 1 000 x 0.5132
= R 513.20 (lower discount rate, 10%, higher PV)
To summarise:
• The higher the risk, the higher the discount rate (RROR), the lower
the present value of the investment.
• The lower the risk, the lower the discount rate (RROR), the higher
the value of the investment.
5. THE BASCIC VALUATION MODEL
Basically, assets are valued in the same way, in three steps:

Step 1
Estimate the cash flow stream.
Find out the expected cash flow for each period and the riskiness of
that cash flow.

Step 2
Determine the required rate of return for each cash flow. This is
based on how risky that cash flow is and what returns you could get
on other investments (opportunity cost).

The required rate of return could be constant over time or you may
need to use different rates for each cash flow.

Step 3
Discount each cash flow by its required rate of return to find its
present value. Then add up the present values to find the intrinsic
value of the asset.

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