Valuation of Securities

Richa Kumar

Richa Kumar

What is Value of an Asset?

An asset is a tangible object or intangible right owned by a person or organization, which carries probable future benefit. 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

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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 In this chapter, we shall discuss how the intrinsic value of a financial asset like debenture, preference share or equity share can be determined.

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Determinants of Intrinsic Value

Since an asset is a bundle of future benefits, there are two primary determinants of the intrinsic value of an asset to a person or organization: The size and timing of the expected future benefits/cash flows The persons required rate of return (this is determined by a number of other factors such as risk/return preferences, returns on competing investments, expected inflation, etc.) Note that the intrinsic value of an asset can be, and often is, different for each individual (thats what makes markets work)

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Value of an financial asset

The benefits from a financial asset are in the form of cash flows on account of periodic interest/dividend received. In general, the value of an asset is the present value of future cash flows. If we receive an annuity from a financial asset, say a debenture, its value will be V=PV of Annuity= A (Annuity) X ADF( Annuity discount factor) For example in case of debenture the A (annuity will be interest in Rs. and ADF will be taken from annuity table. Recall the PV formula for PV of Annuity discussed in chapter on Time Value of Money Richa Kumar

Value of Annuity: An example

If an asset is likely to offer an annual return of Rs. 1000 for 10 years and the required rate of return / rate of discount is 15% (keeping in view the interest rate prevalent and the risk associated with that asset), how much you should be willing to pay for it? ( or what should be the present value of this asset?) V=A X Annuity Discount Factor (ADF) V=1000 X 5.019 (See Annuity Present Value Table) V= Rs. 5,019

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Debentures
A debenture is a formal document acknowledging a debt. It also contains details of interest payable and repayment of principal A Debenture is a tradeable instrument that represents a debt owed to the owner by the issuer. Most commonly, debenture pay interest periodically (usually semi-annually) and then return the principal at maturity. Thus, any debenture will contain information regarding par value, interest rate it carries and Maturity period after which the principal will be refunded

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Valuation of Debentures

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Par value, Interest Rate and Maturity

Par Value: Par value is the face value of the debenture. This is the principal amount of the debt and interest is calculated on this value. Generally, par value of one debenture in India is Rs. 100 or Rs. 1000 Interest Rate: Also known as coupon rate, this rate is applied on par value to calculate interest. However, in case of partly paid up debentures, interest is calculated only on paid up value of debenture. Maturity: This the period after which the principal shall be repaid back to the debenture-holder.

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Debenture Valuation
As discussed, earlier, cash flows determine the value of an asset There are two types of cash flows that are generated by investment in Debenture : 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 Rs. 1,000) at maturity The following timeline illustrates a typical bonds cash flows for a 10% debenture having a par value of Rs. 1000 with maturity period of 5 years
100 100 2 100 3 100 4 1,000 100 5

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Debenture Valuation: An Example

Assume that you are interested in purchasing a bond having a face value of Rs1000 with 5 years to maturity and a 15% coupon rate. If your required return is 10%, what is the highest price that you would be willing to pay? It should be equal to the intrinsic value of the debenture: V=I (ADFI) + F (DFF) Where I= Interest payable at the end of each period ADFI= Annuity Discount Factor applicable ( the required rate of return or discount rate) F= Face value or par value of debenture DFF= Discount Factor applicable

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Debenture Valuation: An Example (cont..)

In the example: I= Rs. 150 ( 15% of Rs. 1000) ADFI= 3.791 ( for annuity for 5 years at discount rate of 10)% DFF + 0.621 ( Discount factor for future cash flow after 5 years at 10% discount rate) Thus, V= I ( ADFI)+F (DFF) V= 150 ( 3.791) + 1000 ( 0.621) V= 568.65 + 621 = Rs. 1189.65 Thus, an investor should not be willing to pay more than Rs. 1189.65, which is its value.

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Present Value of Re 1

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Relationship between Rate of interest and Discount Rate ( required rate of return)
If the Rate of interest and Discount Rate ( required rate of return) are equal, the value of debenture will be equal to par value/face value or paid up value, as the case may be. If the Rate of interest payable is higher than the required rate of return( as was the case in the previous example), the value of debenture will be higher than par value/face value or paid up value, as the case may be. If the Rate of interest payable is lower than the required rate of return the value of debenture will be lower than par value

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Relationship between rate of interest and required rate of return : Example 1

FV= Rs. 1000 Rate of interest= 15% p.a. Required rate of return/Discount rate= 15% p.a. Maturity Period= 5 years V= I ( ADFI)+ F(DFF) V= 150(3.352) + 1000(0.497) V= 502.80 + 497 = Rs. 999.80 or Rs. 1000 approx. So, if the two rates are same, the value of debenture is equal to face value.

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Relationship between rate of interest and required rate of return : Example 2

FV= Rs. 1000 Rate of interest= 15% p.a. Required rate of return/Discount rate= 12% p.a. Maturity Period= 5 years V= I ( ADFI)+ F(DFF) V= 150(3.605) + 1000(0.567) V= 540.75 + 567 = Rs. 1107.75 or Rs. 1108 approx. So, If the Rate of interest payable is higher than the required rate of return, the value of debenture will be higher than face value

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Relationship between rate of interest and required rate of return : Example 3

FV= Rs. 1000 Rate of interest= 10% p.a. Required rate of return/Discount rate= 12% p.a. Maturity Period= 5 years V= I ( ADFI)+ F(DFF) V= 100(3.605) + 1000(0.567) V= 360.50 + 567 = Rs. 927.50. So, if the Rate of interest payable is lower than the required rate of return, the value of debenture will be lower than face value.

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Required or expected rate of return

So far, we assumed the expected/required rate of return or the discount rate. Where do we get this rate? How do we calculate this the discount rate. This rate is nothing but what is also called yield on debenture, which depends up the Annual Interest and Market Price of the irredeemable Debenture Yield = Ai/MPd The yield on a 10% irredeemable debenture of Rs. 1000 face value having a current market price of Rs. 800, is thus Yd=100/800= 0.12= 12%

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Yield on Redeemable Debentures

The Yield on Redeemable Debentures is also called Yield to Maturity (YTM). It is approximately equal to: YTM= [Ai + (F-P)/N]/[(F+P)/2] Where Ai= Annual Interest F=Face value of debenture P= Current Market Price of Debenture N= Period of Maturity of Debenture

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Yield on Redeemable Debentures: An Example

For a 9% debenture with face value of Rs. 1000 redeemable at par after 8 years, having a current market value of Rs. 800, the YTM can be calculated as follows Ai= Rs. 90 F=Rs. 1000 P= Rs. 800 N= 8 years YTM= [Ai + (F-P)/N]/[(F+P)/2] YTM= [90 + (1000-800)/8]/[1000+800)/2] YTM= (90+25)/(1800/2)= 115/900=0.127 or 12.7%

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Valuation of Shares

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Common Stocks
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. In the event of liquidation of the firm, the common shareholders will receive a pro-rata share of the assets remaining after the creditors and preferred stockholders have been paid off.

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Valuation of Preference Shares

Generally, preference shares carry a fixed rate of dividend. Therefore, valuation of preferences shares can be done on the same basis as that of debentures Preference shares may be redeemable or irredeemable.

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Valuation of Redeemable Preference shares

In case of redeemable preference shares, the valuation will be on the same basis as adopted in case of redeemable debentures. It will be equal to present value of annual dividend stream (annuity of dividends) plus the present value of the amount payable on maturity Thus, Vps= V=D(ADFI) + F (DFF) Where D= Dividend payable at the end of each year ADFI= Annuity Discount Factor applicable ( the required rate of return or discount rate) F= Face value of preference share DFF= Discount Factor applicable

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Valuation of Redeemable Preference shares : An Example

The value of a 10% Preference Share redeemable after 10 years with par value of Rs. 100, given the required rate of return in the market being 15% the value of the share can be calculated as follows: Vps= D(ADFI) + F (DFF) D=Rs. 10 (10% of Rs. 100) ADFI= 5.019 (See Annuity PV table) F= Rs.100 DFF= 0.247 ( See PV Table) Vps= 10 X 5.019 + 100 X 0.247 = 50.19 + 24.70 Vps= Rs 74.89

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Valuation of Irredeemable Preference Shares

In case of Irredeemable preference shares, the cash flows are only in the form of dividends. But these cash flow are perpetual for indefinite period. Valuation is done in such case as it is done in case of irredeemable debentures. Vps= Dp/Yp Dp= Dividend per preference share Yp= Yield on a preference share

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Valuation of Irredeemable Preference Shares: An Example

The value of 10% irredeemable preference shares of face value Rs. 100, if the such type of preference shares carry a dividend of 15% (required/expected rate of return), the value can determined as follows: Dp= Rs. 10 Yp= 15% Vps= Dp/Yp= 10/0.15= Rs. 67 Yield can be calculated in the same way as is done in case of irredeemable debentures (Yield = Ai/MPd)

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Valuation of Equity Shares

Valuation of equity shares is more difficult than the valuation of debentures and preference shares. It is so because of two reasons: Unlike debentures and preference share, equity shares do carry any fixed rate of dividend. Hence, there is uncertainty regarding the future stream of returns (dividends) from equity shares Earnings and thus dividends on equity shares are likely to grow unlike the interest on debentures and dividends on preference shares Equity shareholders bear the risk of changes in earnings of the company and thus also benefit if the earnings of the company increase.

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Two Alternative Approaches to Valuing Equity Shares

The value of equity may be assessed on the basis of expected cash flows from dividends and also on the basis of the expected earnings of the company as the earnings of the company will determine the value of the company, on which these shareholders have exclusive share. Thus, there are two basic approaches to valuation of equity shares: Dividend Capitalization Method Earnings Capitalization Method

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Dividend Capitalization Method

According to this approach, the value of an equity share is equal to the present value of future dividends, plus the present value of price expected to be realized on the re-sale. In this approach, we assume that a) Dividends are paid every year b) Dividend is received after the expiry of an year of purchase of equity share There are two models under this approach Single Period Valuation Model Multi-Period Valuation Model

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Single Period Valuation Model

In this model, it is assumed that an investor expects to hold equity share for one year only. In such a case, the value of share should be equal to present value of dividend at the end of year and present value of price expected to be received on selling the share after one year. Ves= P0=PV(D1) + PV(P1) Or Ves= [D1/(1+Ke)] + [ P1/(1+Ke)] P0= Current Price of equity share D1= Expected dividend per share at end of first year P1= Expected market price of share at end of first year Ke= The required rate of return or capitalization rate

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Single Period Valuation of Equity Share: An Example

If the expected dividend on an equity share is Rs. 20 at the end of the current year and the share is expected to have a market price of Rs. 180 after one year, what should be the value of the share, given the required rate of return is 12%. D1= Rs. 20 P1= Rs. 180 Ke= 12% P0=[D1/(1+Ke)] + [ P1/(1+Ke)] P0=20/1.12 + 180/1.12= 17.86 + 160.71 P0= Rs. 178.57

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Multi-Period Valuation Model

As equity shares are not redeemable, i.e. they do not have any maturity period; the cash flows in the form of dividend can be expected to be perpetual or for indefinite period. In that case, the value of equity share can be taken to be equivalent to present value of its stream of expected dividends. In such a case, one can calculate the value of equity share as is done in case of irredeemable debentures or preference shares P0=De/Ke

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Multi- Period Valuation of Equity Share: An Example

ABC Ltd is currently paying Rs. 40 per share as dividend each year and it is expected that it will not deviate from this dividend policy. If the current capitalization rate is 15%, what value will you assign to it share? P0=De/Ke P0=40/0.15 P0=Rs. 267

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Multi- Period Valuation of Equity Share with expected growth in rate of Dividend
In the earlier example, the dividend was assumed to be constant throughout the life of the company. This may not be realistic assumption as the dividends per share of companies grow over time due to increase in the earning per share. The valuation of share in that case needs to calculated after adjustment in the formula for expected growth in the income However, the expected growth may be constant or variable.

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Valuation of Equity Share with expected growth in Dividend being constant: An example
A company is paying a divided of Rs. 40 per equity share. Dividends are expected to grow perpetually at 10%. Given that the rate of capitalization is 15%, what should be the value of the share of the company? P0=De/(Ke-g) P0=40/(0.15-0.10) P0=40/0.05 P0= Rs. 800

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Thanks

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