Valuation of Securities

By ;- ) Ajay rana , Sonam gupta , Shivani , Gurpreet , Shilpa

What is Value?

In general, the value of an asset is the price that a willing and able buyer pays to a willing and able seller Note that if either the buyer or seller is not both willing and able, then an offer does not establish the value of the asset

Securities can be classified into two groups for the purpose valuation ; 1. Fixed income securities 2. Fluctuating income securities

Fixed income securities These securities are the ones on which the issuing company is bound to pay or has an obligation to provide regular returns at a fixed rate to investors in the form of interest or dividend payment . These are ; 1. Debentures / bonds 2. Preference shares Fluctuating income securities These securities are the ones on which the issuing company is not bound to pay or has no obligation to provide regular returns at a fixed rate to investors in the form of interest or dividend payment. These are Equity shares of a company .

Several Kinds of Value

There are several types of value, of which we are concerned with three: Book Value - The assets historical cost less its accumulated depreciation Market Value - The price of an asset as determined in a competitive marketplace Intrinsic Value - The present value of the expected future cash flows discounted at the decision makers required rate of return

Bonds1.

2.

A bond is a tradable instrument that represents a debt owed to the owner by the issuer. Most commonly, bonds pay interest periodically (usually semiannually) and then return the principal at maturity. Most corporate, and some government, bonds are callable. That means that at the companys option, it may force the bondholders to sell them back to the company.

Types of Bonds 1.

Government Bonds - These basically long term bonds issued by RBI on behalf of GOI. Corporate Bonds - Companies borrow money by issuing bonds called corporate bonds or corporate debentures.

2.

Types of Corporate Bonds

1. 2.

3.

4.
5.

Straight Bonds - It is also called as plain vanilla bond. It pays fixed periodic coupon over its life and returns the principle on the maturity date. Zero Coupon bonds - It does not carry regular interest payments. It is issued at a step discount on face value and redeemed at face value on maturity. Floating Rate bonds - These do not pay fixed interest but pay a benchmark rate such as the treasury bill interest rate. Commodity Linked Bonds - The pay off on commodity linked bonds depends to a certain extent on the price of the commodity. Bonds with embedded options These options give certain rights to the investors or issuers:
1. Convertible Bonds - Gives the bond holder the right to convert them into equity share on certain terms 2. Callable Bonds - Gives the issuer the right to redeem the bonds issued by them on certain terms 3. Puttable Bonds - Gives the investor the right to prematurely sell the bonds back to the issuer on certain terms.

Bond Yields Bonds are generally traded on the basis of their prices. However they are not usually compared on the basis of their prices because of significant variations in their cash flow patterns and other features. Instead they are compared in yields.
Commonly employed yield measures Current Yield 1. It related the annual coupon interest to the market price. Current yield= Annual Interest/Price Eg : The current yield of a 10 year and 12% coupon rate bond with par value of Rs.1000 and selling of Rs.950 is = .12*1000/950 = 12.63 2. It reflects only coupon interest rates. It does not consider capital gain or loss that an investor will realize if the bond is purchased at discount or premium. It ignores time value of money

Yield to Maturity This method is employed to anticipate the gross rate of returns offered by the bond over its life.

C= Annual Interest in Rupees M=Maturity Value in Rupees n=No of years left to maturity P=Price of bond r=Coupon Rate

Eg: A Rs.1000 par value bond carrying a coupon rate of 9% and maturing after 8 years .The bond is currently selling for Rs.800. What if the YTM on this bond?
800= [90/(1+r) 8]+ [1000/(1+r) 8] By hit and Trial =90 (PVAF 12%,8 yrs) + 1000 (PVF 12%,8 yrs)= Rs.851.0 =90 (PVAF 14%,8 yrs) + 1000 (PVF 14%,8 yrs) =Rs. 768.1 =90 (PVAF 13%,8 yrs) + 1000 (PVF 13%,8 yrs) =Rs. 808 Applying interpolation: 13%+(14%-13%)*(808-800/808-768.1)=13.2% OR YTM = C+(M-P)/n = 90+(1000-800)/8 = 13.1% 0.4M+0.6P 0.4*1000 + 0.6*800

Yield to Call Some bonds carry a call feature that entitles the issuer to buy back the bonds prior to the stated maturity date. For such bonds both YTC and YTM are calculated: YTC=[C/(1+r) t]+ [M*/(1+r) n*] Where n*= No of years until the call date M*=Call Price

Risks in Bond 1. 2. 3.

4.

5.

Inflation Risk - The interest rates are declared in nominal terms. Thus it should be adjusted with the expected inflation. Default Risk -It is the risk that the borrower may not pay the interest or principle on time. Call risk - The issuer may buy back the bond when the interest rates are declining. This risk is attractive from the issuer point of view but not from the investor point of view. Liquidity Risk - Barring for some of the popular govt securities most of the debt instruments are not traded actively. Thus there is poor liquidity in the debt market and the investors face difficulties in trading the same. Reinvestment Risk - When the bond pays periodic interest there is a risk that the interest payments may have to be reinvested at a lower interest rate. This risk is greater for bonds with longer maturity and higher interest payment.

Risks in Bond (Conti.)

6. Foreign Exchange Risk - If a bond has payments that are dominated
by foreign currency it rupee cash flow is uncertain as there is a risk of depreciation of rupee in comparison to foreign currency. 7 .Interest Rate Risk - Interest rates tend to vary causing fluctuations in bond prices.

Bond Terminology 1.

There are several terms with which you must be familiar to solve bond valuation problems:
1. Coupon Rate - This is the stated rate of interest on the bond. It is fixed for the life of the bond. Also, this rate time the face value determines the annual interest payment amount. 2. Face Value - This is the principal amount (nominally, the amount that was borrowed). This is the amount that will be repaid at maturity 3. Maturity Date - This is the date after which the bond no longer exists. It is also the date on which the loan is repaid and the last interest payment is made.

Calculating the Value of a Bond 1.

There are two types of cash flows that are provided by a bond investments:
1.
2.

Periodic interest payments (usually every six months, but any frequency is possible) Repayment of the face value (also called the principal amount, which is usually $1,000) at maturity

2.

The following timeline illustrates a typical bonds cash flows:

1,000 100 5

100 0 1

100 2

100 3

100 4

Calculating the Value of a Bond (cont.)

Redeemable Bond Vd=I(ADFI)+F(DFF)
Vd= Value of Bond or Debenture I=Interest Payable on bond/Coupon Rate ADFI=Annuity discount factor applicable to interest DFF= Appropriate discount factor applicable to face value F= Face Value

Irredeemable Bond

Vd=A/i A=Interest Amount i = Expected Rate of Interest

Bond Valuation: An Example

Assume that you are interested in purchasing a bond with 5 years to maturity and a 10% coupon rate. If your required return is 12%, what is the highest price that you would be willing to pay?
100 0 1 100 2 100 3 100 4 1,000 100 5

= Present value for annuity for 100 @ 12% + present value of 1000 for 5 years @ 12%

Some Notes About Bond Valuation

1. 2.

The value of a bond depends on several factors such as time to maturity, coupon rate, and required return We can note several facts about the relationship between bond prices and these variables:
1. 2. 3. Higher required returns lead to lower bond prices, and viceversa Higher coupon rates lead to higher bond prices, and vice versa Longer terms to maturity lead to lower bond prices, and viceversa

Valuation of debenture / Bonds

A debenture/bond is a tradable instrument that represents a debt owed to the owner by the issuer. Most commonly, bonds pay interest periodically (usually semiannually) and then return the principal at maturity.

Debentures can be classified as ;1. Redeemable 2. Non redeemable / Perpetual 3. Convertible

Valuation Mechanism

Valuation of Redeemable Debentures Valuation of Deep Discount Debentures / Bonds Valuation of Non redeemable Debentures Valuation of Convertible Debentures

Valuation of Redeemable Debentures

Value of these debentures is the present value of inflows to be received by the investor in future. The inflows are like regular interest payment every year , till the date of maturity and the payment of maturity value at the end of maturity period.

CALCULATION :-

Formula ;-

Vd = I X PVIFAr,n +M X PVIFr,n
Here

Solution -

Valuation of Deep Discount Debentures / Bonds

a deep discount debenture is the one , which does not carry any rate of interest and where the company is not bound to pay interest at regular intervals . Herein , it is issued at a discount to face value and redeemable at par on the maturity . The discount rate is the investors required rate of return . CALCULATION :FORMULA - Vd = M x PVIFr,n

Solution -

Valuation of Non redeemable Debentures

A perpetual debenture is the one in which a company is to pay the interest at a regular interval throughout the life of the company , but the principal amount is not refunded by the company during its life time . Therefore , the investor will receive only the interest every as specified by the company , the value of this is nothing but the value of a perpetuity discounted at investors required rate of return . FORMULA

Vd= I/r x 100

Solution -

Valuation of Convertible Debentures

FORMULA

Vd= I x PVIFAr,n + M x PVIFr,n

Solution -

Valuation of preference share Features of preference shares are similar to debentures , with the only difference that in preference shares , the company pays the dividend and in case of debenture , it the interest . Therefore , value of preference share can be calculated in the same way as in debentures . Preference shares can be different types redeemable , non redeemable and convertible . The same formulae and process of debentures valuation can be applied with the little change of replacing the interest amount with the dividend amount . Preferred stock represents an ownership claim on the firm that is superior to common stock in the event of liquidation. Typically, preferred stock pays a fixed dividend periodically and the preferred stockholders are usually not entitled to vote as are the common shareholders.

Redeemable Preference Share FORMULA Vp=D(ADFD)+F(DFF) here , Vp= Value of Preference Share
D= Dividend Payable on Preference Share ADFD=Annuity discount factor applicable to dividend DFF= Appropriate discount factor applicable to face value F= Face Value

Irredeemable Preference Share

FORMULA Vp=D/Kp here , D= Dividend Amount Kp =Current Yield

Valuation of equity A share of common stock represents an ownership position in the firm. Typically, the owners are entitled to vote on important matters regarding the firm, to vote on the membership of the board of directors, and (often) to receive dividends. There are three method of valuation of equity 1. Balance sheet valuation 2. Dividend discount model 3. Free cash flow model

Common Stock Valuation

1.

2.

Just like with bonds, the first step in valuing common stocks is to determine the cash flows For a stock, there are two:
1. 2. Dividend payments The future selling price

3.

Again, finding the present values of these cash flows and adding them together will give us the value

Balance sheet valuationThree measures derived from the balance sheet are; 1. Book value, 2. liquidation value, and 3. Replacement cost. Book value : The book value per share is simply the net worth of the company divided by the number of shares. Liquidation value : The liquidation value per share is equal to:
Value realised - Amt. paid to creditors &pref. sh. Holders. number of outstanding shares Replacement cost : The use of this method is based on the premise that the market value of a firm cannot deviate too much from its replacement cost.

Dividend discount model

1.

2. 3. 4.

The value of an equity share is equal to the present value of dividends expected from its ownership plus the present value of the sale price expected when the equity share is sold Assumptions Dividend paid annually 1st dividend is received 1 year after purchase

Types of dividend discount model 1. 2. 3. 4. 5.

Single-period valuation model Multi-period valuation model Zero growth model Constant growth model Two stage growth model

Single period valuation model

1.

Where the investor expect to hold the equity share for one year.

1.

Expected rate of return

Multi period valuation model

This is more realistic and complex
P0 = D1 + D2 + Dn n (1+r) (1+r)2 (1+r)

Common Stock Valuation: An Example

Q. Assume that you are considering the purchase of a stock which will pay dividends of $2 next year, and $2.16 the following year. After receiving the second dividend, you plan on selling the stock for $33.33. What is the intrinsic value of this stock if your required return is 15%?
? 2.00 33.33 2.16

VCS

1.15

2.00

2.16 33.33

1.15

28.57

Zero growth model:

This model is applicable when the dividend per share remains constant year after year at a value of D. Po = D/r

Constant Growth model:

It assumes that the dividend received by the shareholder will grows at a constant rate.

OR,

Calculating Value of Equity :

Valuation of equity when there is a constant growth rate in dividend for a finite period

D1 VCS k CS g k CS g
D0 = Current Dividend D1 = Expected Dividend g = Growth Rate of Dividend Kcs = Expected Return on common stock Vcs = Value of Common Stock

D 0 1 g

An Example

Recall our previous example in which the dividends were growing at 8% per year, and your required return was 15% The value of the stock must be:

VCS

185 . 1.08 .15.08

2.00 28.57 015 . .08

Calculating Value of Equity :

When there is constant growth of dividend for infinite period (Earning Capitalisation Approach) V = Amount of Dividend / Ke For Example: ABC Ltd is currently paying dividend @ Rs.60 .The current yield is 15%. Calculate the value of share. Answer : 60/.15 = 400

Two stage growth model :

This is the extension of the constant growth model assumes that the extraordinary growth will continue for a finite number of years and there after the normal growth rate

H model ;
1.

2.
3. 4.

Assumptions: Current dividend growth rate is higher(ga) After 2H year the growth rate become gn. At H year the growth rate is exactly halfway between ga and gn. Po = D0[(1+gn)+H(ga-gn)]/ r-gn or P0 = D0(1+gn)/r-gn +D0h(ga-gn)/r-gn

Free cash flow models

This model broadly involves determining the value of the firm as a whole by discounting the free cash flow to investors and then subtracting the vale of pref. and debt to obtain the value of equity. Total return = Dividend yield + capital gain yield Divide the future value in two parts, the explicit forecast period and the balance period. Forecast the free cash flow, year by year, during the explicit forecast period FCF= NOPAT- net investment Calculate the weighted average cost of capital WACC= WeRe + WpRp.WdRd(1-t) Establish the horizon value Vh=FCFH+1/WACC-g Estimate the enterprise value Drive the equity value Ent. Value Pref. Value Debt value Compute the value per share