Security valuation

The basic valuations model

 Value of a security is a fundamental variable and depends

on its promised return, risk and the discount rate.
 You may recall the basic understanding of present value
concept, with the mention of fundamental factors like
returns and discount rate.
 In fact the basic valuation model is none else than present
value procedure.
Given a risk adjusted discount rate and the future
expected earnings flow of security in the form of
interest, dividend, earnings, or cash flow, you can
always determine the present value of follows.

PV = CF1 __ + CF2 + CF3 + ……. CFn

1+r (1 + r)2 (1 + r)3 (1 + r)n
PV = Present value
CF = Cash flow interest, dividend, earnings per time
period up to ‘n’ number of years
r = Risk adjusted discount rate
Time value of money affects the valuation of
THE VALUATION PROCESS OF SECURITIES

 Investment process requires the valuation of securities in

which the investments are proposed.
 The value of a security may be compared with the price of
the security to get an idea as to weather a particular security
is overpriced, under-priced or correctly priced.
 Hence, the valuation is the key concept for investment
decisions. No buy-sell action will take place without values.
CONT’D…
 The basic valuation is a constant exercise rationality with cost,
benefits, and uncertainty as important variables.
 The valuation process will be examined in view of the
performance of a firm in relation to the performance of industry
to which it belongs; and the industry performance in turn, is
linked to performance of the economy and the market in general.
 We apply the TVM concept to find out the value of different
types of securities
 Different types of securities that will be covered are

Debentures(Bonds)
Preference Shares
Equity shares
Cont’d…
Generally, a financial security will have the potential to
generate some additional return above face value in the
future.
Thus we can say that the value of a security is the “present
value of the future benefits” associated with it.
1. Valuation of debentures
 A bond or debenture is a debt security issued by a borrower
and subscribed/purchased by a lender/investor.
 Bond is a usual form of long-term financing used by the
firms, which upon issuing a bond, promise to make certain
cash flows in future (in the form of interest and/or
repayment) under clearly defined terms and conditions.
 In corporate finance, the term is used for a medium-to-
long-term debt instrument used by large companies to
borrow money.
 In some countries the term is used interchangeably
with bond, loan stock or note.
Cont’d…

Important terms associated with Debentures

 Face value/par value: The amount on which the issuer pays
interest, and which, most commonly, has to be repaid at the
end/maturity.
 Coupon rate of interest: the interest rate that the issuer pays
to the bond holders. Usually this rate is fixed throughout the
life of the bond.
 Maturity date: The date on which the issuer has to repay the
FV.
 As long as all payments have been made , the issuer has no
more obligation to the bond holders after the maturity date.
 The length of time until the maturity date is often referred to
as the term or maturity of a bond.
Cont’d…

 The intrinsic value of a bond(PV) is equal to

the present value of its expected cash flows.
 If the coupon interest payments and principal
payments are known and the present value is
determined by discounting these future
payments from the issuer at an appropriate
discount rate or market yield.
Cont’d…
 Required Rate of Return(kd). The required rate of return
refers to the yield which the investor wants to earn by
making investment.
 It is consisting of two elements – the risk free rate of return
and the risk premium.
kd= rf + rp
Where:
 Kd= Required rate of return,
 rf=the risk free rate,
 rp =The risk premium
 Debenture valuation model
An investor of debenture is entitled to get the following
two things.
Interest at a fixed rate till maturity
Principal amount of the debenture on its maturity date

The usual present value calculating are made with the help
of the following equation.
C FV

n
PV = 
Where:
t 1
(1  r n (1  r ) n
PV = Present value of the bond today
C = Coupon rate of interest
FV = face value repayable
r = Appropriate discount rate or market yield
n = Number of years to maturity
Cont’d…
 PV =PV of all the future interest inflows +PV of the FV paid at
the maturity. Then,
 PV=PVIFA*Annual interest payment+PVIF*Face value

Pv= ppmt +

1  (1  k )  n  FV
 
 k  (1  k ) n

Where: ppmt= periodic payment

k= RRR
FV= Face Value of the bond
n= Period of the bond until maturity
Example
A bond of birr.1000 bearing a coupon rate 12% is redeemable at
par in 10 years. Find out the value of the bond if:
1. Required rate of return is 12% or 10% or 14%
2. Required rate of return is 14% and the maturity period is 8 years
or 12 years;
3. Required rate of return is 12% and redeemable at birr 950 or
birr1050 after 10 years.
Cont’d…
Solution to the value of the bond can be ascertained
by the equation

1  (1  k )  n FV
Pv = pmt[ ] +(1  k ) n
k
Cont’d…
Now the value of the bond under different situations can be
ascertained as follows:
1. Basic information
Coupon rate 12%
Redeemable at par
Maturity 10 years.
a. If required rate of return is 12%
PV = 120(5.650) + 1000(0.322)
= 678 + 322
= birr.1000
b. If required rate of return is 10%
PV = 120(6.145) + 1000(0.386)
= 737.4 + 386
Cont’d…
c. If required rate of return is 14%
PV = 120(5.216) + 1000(0.270)
= 625.92 + 270
= birr.895.92
2. Basic Information
Coupon rate 12%
Redeemable at par
Maturity 8/12 years.
Required rate of return 14%
a. If maturity period is 8 years
PV = 120(4.639) + 1000(0.351)
= 556.68 + 351
=birr 907.68
Cont’d…
b. If required period is 12 years
PV = 120(5.660) + 1000(0.208)
= 679.20 + 208
= birr 887.20
3. Basic information
Coupon rate 12%
Required rate of return 12%
Maturity 10 years.
a. If redemption amount is birr.950
PV = 120(5.65) + 950(0.322)
= 678 + 305.90
= birr.983.90
b. If redemption amount is birr.1050
PV = 120(5.650) + 1050(0.322)
= 679.2 + 338.1
Bond valuation Behavior
On the basis of the above calculation, certain conclusions
regarding the behavior of the valuation of bond can be arrived as
follows:
i. Relating to the required rate of return:
k=c sold at par
k<c sold at premium
k>c sold at discount
Cont’d…
ii. Relating to maturity period:
 Whenever the required rate of return is different from the coupon
rate, and assumed constant until maturity the time to maturity
also affects the value of the bond.
 Further, the longer the time to maturity of bond, the greater its
value changes in response to a given change in the required rate
of return.
Semi annual interest rate and valuation of the bond

 This is the case when the interest is payable semi annually(twice

in a year)
 To calculate the value of the bond

Divide the coupon rate ,c, by 2

Divide the required rate of return ,k, by two.
Multiply the maturity period by 2
Do the calculations as before for the annual
compounding
Valuation of deep discount bonds (DDB’s)
In recent years, some financial institutions have issued a debt
instrument known as DDB. These DDB’s have an issue price and
a par value or a face value which is payable to the holder of
DDB.
 No interest or any other type of Payment is available to the
holder before maturity.
 Since there is no intermediate payment between the date of issue
and the maturity date, these DDB’s may also be called the zero
coupon bonds.
Cont’d…
 The valuation of DDB’s can be made on the same lines as
the ordinary bonds are valued. As DDB generates only one
future cash flow at the time of maturity, the value of the
DDB may be taken as equal to the present value of this
future cash flow discounted at the required rate of return of
the investor for the number of years of the life of DDB’s.
 The value of DDB can be calculated with equation

PV(DDB) = FV/ (1+r)n

Where:
PV(DDB)= present value of the DDB
FV= face value of DDB payable at maturity
r= the required rate of return
n= life of the DDB
Example
A DDB is issued for maturity period of 10 years and having a par
value of birr 25,000. Find out the value of the DDB given that
the required rate of return is 15%
Applying the equation above the value of the DDB is:
PV(DDB) = 25,000/(1+0.15)10
= 25,000*0.247
= birr 6,175
So the value of the bond is birr 6,175
Valuation of perpetual debenture

Perpetual debenture is:

 A debenture that never matures
 Rarely found in practice

Vdp=Annual interest payment/Required rate of return

Vdp=ppmt/kd
Example
A debenture holder is to receive an annual interest @
10% for perpetuity. The face value of the debenture is
birr 1000. Calculate the value of the debenture if the
required rate of return is:
 if kd = 15%
PV= Birr 667
 if kd = 8%
PV= Birr 1250
 if kd = 10%
PV= Birr 1000
Yield to maturity (YTM)
 itis already stated that the cash flows in relation to a bond are
consisting of a regular interest payments and the redemption
repayment.
 The rate of return kd, which makes the discounted values of
these cash flows equal to the bond’s market value, is known as
the YTM of the bond.
 So, a bond’s YTM may be defined as the Internal Rate of
Return (IRR) for a given level of risk.
 When an investor evaluates bonds in order to make a buy or
not to buy decision, the evaluation is often done by finding out
the IRR of the bond.
Cont’d…
 While finding out the YTM, an implied assumption is that all
interest received are reinvested at a rate of return equal to bond’s
YTM.
 The trial-and-error procedure required to find out the YTM
2. VALUATION OF PREFERENCE SHARES
 Preference share is a share which entitles the shareholder to
receive:
(i) a dividend at a fixed rate for a given period
(ii) a redemption amount at the time of preference share ( in case
of redeemable preference share) OR a dividend at the fixed rate
perpetually till the liquidation of the company (in case of
irredeemable preference share)
Cont’d…
Two assumptions are relevant while ascertaining the
value of preference shares:
1. The dividend on preference share are received once
a year and that the first dividend is received at the
end of one year from the date of acquisition /
purchase
2. The company always intends to pay the preference
dividend so that the stream of preference
dividend is concerned to be known with certainty
Cont’d…
 Preference shares
Carry a fixed dividend and thus their valuation can
be done on the same basis as the bonds
Two types of preference shares
Redeemable: Both annual dividend and a maturity
amount is payable.
Irredeemable: Only annual interest is payable
Valuation of Redeemable preference shares
These future cash flows are discounted at an appropriate rate to
find out the value of the redeemable preference shares as follows:

P0 = [d1/(1+kp)1] + [d2/(1+kp)2]+ ….+ [dn/(1+kp)n+ [RV/(1+kp)n

P0 =PVIFA*Annual dividend Payment + PVIF*Amount

payable at Maturity
Where:
P0 = value of preference share
Di = annual fixed dividend
RV = redemption value of preference share
Example
A Preference share of birr 1000 carries a dividend rate of 10%.
The current market interest rate is 15%. The preference share
becomes due for redemption in 10 years. Find the value of the
preference share?
Solution
PO =Annual dividend Payment * PVIFA + PVIF*Amount
payable at Maturity
= Birr 748.90
Valuation of irredeemable preference shares
Have Single component Annual dividend cash inflow
Value(PO)= Annual dividend cash inflow/Current
yield
Eg. Face value of preference share=birr 100, Dividend rate @10%,
Current yield on the preference share=15%
Vps=10%(100)/0.15
= Birr 67
Yield on the preference share can be calculated on the same
patterns as calculated for the Debentures
3. VALUATION OF EQUITY SHARES
Conceptually, the valuation of the equity share is the most typical
because of its residual ownership character. The equity
shareholders receive the residual profit and also the residual
assets in case of liquidation.
From the point of view of calculation also, the
valuation of equity share is difficult for:
i. There is no fixed dividend associated with the
equity
ii. The rate of dividend on equity share may be varying over the
years
Cont’d…
Different approaches, however, make the following assumptions
regarding the basic characteristics of equity shares.
a. Equity share does not have any redemption rate.
b. Equity share do not have any given redemption or
liquidation value
c. Dividends on equity shares are neither guarantied nor
compulsory. Further, neither the rate nor the timing of
dividend is specified
Cont’d…
 Two approaches to valuation of equity shares
 Dividend capitalization approach
 Earning capitalization approach
Cont’d…
 DCA approach is based on the following assumptions
 Dividends are paid annually
 The dividend is received after the expiry of the purchase year of
the equity share
 DCA approach again divided into the following two categories
 No growth in dividends
 Growth in dividends
Cont’d…

Dividend Capitalization Approach can be classified

into:
1. No growth in dividends
Single period approach
Multiple period approach

2. Growth in dividends
Constant growth on year to year basis
Variable growth in dividends on year to year
basis
1. DCA approach (No growth in dividends)

Classified into:
a. Single period approach
 The investor is presumed to hold the share for one year
only.
 In such case the cash inflow for the investor are
 Dividend that will come after one year
 The price of the share that he/she may get after one
year
Present value of the share
 PV of the dividend + PV of the market price of share after
one year
 Po=Do/(1+k)1 +P1/(1+k)1
Example
Mr. A holds an equity share giving him an annual dividend
of birr 20.He is expected to sell the share at birr180 after one
year. Calculate the value of share at present. The required
rate of return(discount rate ) is 12%.
Solution
P = 20/(1+0.12) + 180/(1+ 0.12)
= birr 178.57
Cont’d…
b. Multiple period approach
The investor is presumed to hold the share
beyond one year for an unspecified no of years
Equity shares don’t have any maturity period
One can expect the dividend cash inflow for
infinite period
This kind of cash flow is similar to the cash flow
of a perpetual debenture(one with no Maturity)
So valuation can be done in similar way
Cont’d…
Po=Expected Annual dividend/Discount rate
Po=D/k
Example
A company is paying an annual dividend of birr40 per share.
The company is expected not to deviate from this dividend
amount in the future. Current discount rate is 15%.Calculate
the present value of the share?
Solution
Po= D/k
= 40/.15
= Birr267
2. DCA approach (Growth in dividends)

The assumption of constant dividend without any growth is

unrealistic as companies grow over time. So growth in dividends
needs to be incorporated.
The model changes if the growth in dividends also taken care of.
i. DCA Approach(Constant growth in Dividends)

Po=D1/(k-g)
Where:
D1= Dividend at the end of first year
k= discount rate
g=growth rate of dividends(in %)
The above formula can also be written as
Po=Do(1+g)/(k-g)
Example
ABC limited is expected to pay dividend of birr 40 per
share.. The dividends are expected to grow at a rate of 10%.
The capitalization rate is 15%. Find the value of share?
solution
D1= Birr 40
g = 10%, k =15%
Po= D1/k-g
= 40/.15-.10
= 40/.05
= 800 birr.
ii. DCA(Variable Growth)
The dividends on the Company share may not grow at a constant
rate.
 Two stage dividend growth model

Companies have years of super-normal growth

where the dividend grow at a very high rate
After this super-normal growth period the dividend
s grow at a lower rate.
VALUATION OF EQUITY SHARES BASED ON EARNINGS

 Some firms have extensive growth opportunities and

require funds to take up new projects. So these firms
may retain profits (wholly or partially).This reduce the
amount of dividends to the shareholders.
 The retained earnings are reinvested internally to
generate higher profits in future. Investor are willing to
forego cash dividends today in exchange for higher
earnings and expectation of higher dividends in future.
 The value of an equity share in such a case, may be
determined on the basis of the earnings of the firm.
Cont’d…

The earnings of the firm may be expressed as

earnings as per share(EPS) which is ascertained from
the accounting information of the firm. There are
different approaches to find out the value of the equity
share on the basis of the earnings of the firm.

These include Gordon valuation model, Walter’s

Model, the P/E ratio approach and the explicit resale
price model.
a. The Gordon’s Model
 This valuation model proposes that earnings of the firm are either
distributed among the shareholders or are reinvested within the
business.
 The growth in dividends in future would therefore depend upon
the profits retained and the rate of return on these retained
profits.
 The golden valuation model can be represented as follows:

P0 = EPS1 (1-b)/ ke – br Where Po = price of a share

EPS1 = EPS at the end of year 1
‘b = retention rate,
r = rate of return on reinvestments,
ke = required rate of return
 b. Walter’s Model
 The Walter's model supports the view that the market price of a
share is the sum of
(i)present value of an infinite stream of dividends, and
(ii) present value of an infinite stream of returns from retained
earnings.
 The investors will evaluate the retention of earnings resulting in
lesser dividends, in the light of(a) the rate of return, r, earned by the
company on these retained earnings, and (b) the opportunity cost of
equity investors, ke .
 Depending upon the relationship between r and ke, the investors
will value the expected capital gains and will thus value the share.
The Walter’s Model can be presented as follows:
P = [D/ ke] + (ke/r)(E-D)/ ke
 C. Price earnings ratio(P/E ratio)
 The P/E ratio is the most common earnings valuations Model.
 The P/E ratio between the price of a share & its EPS.
 For eg., if a share whose EPS is ETB. 10 is having market price
of ETB.250, then its P/E ratio is 250/10 =25. it means that the
market price of the share is 25 times that of the EPS.
 As per P/E ratio approach the value of the share is expressed as
 Value(PO) = EPS * P/E ratio
 But there is a question as to how to estimate / forecast the P/E
ratio?
 One method is to estimate the P/E ratio of the similar type of a
company or the industry as a whole.
 Then those estimate may be further adjusted in the light of
characteristics and features of the particular firm and its share.
 SUMMERY VALUE PRICE RELATIONSHIP
 Present value also known as intrinsic value or economic value,
determines the price.
 You have learned the role of buying and selling pressures which
make prices more toward value.
The following are the valuation rules
 Buy when value is more than price.
 This underlies the fact that shares are under priced and it would be a
bargain to buy now and sell when prices move up toward value.
 Sell when value is less than price.
 In a situation, like this, shares would be overpriced and it would be
advantageous to sell them now and void loss when price later moves
down to the level of the value.
 Do not trade when value is equal to price
END OF HAPTER 2