VALUATION OF BONDS AND SHARES

By Jebah Shanthi P

Introduction
Assets can be real or financial; securities like shares and bonds are called financial assets while physical assets like plant and machinery are called real assets. The concepts of return and risk, as the determinants of value, are as fundamental and valid to the valuation of securities as to that of physical assets.

Concept of Value x Book Value x Replacement Value x Liquidation Value x Going Concern Value x Market Value

1. Book Value
It is an accounting concept It is the value recorded in the books or balance sheet of a firm Fixed assets = Historical cost Depreciation Current Assets = shown at market price or cost price whichever is less The liabilities are recorded at their outstanding values The difference between book values of assets and liabilities represents the shareholders networth

Book Value per share = Assets Liabilities = Shareholders Net worth No. of Shares No. of Shares x Book value is easy to calculate x It represents the historical cost and not the real value

Replacement Value: amount required to be spent by the company to replace existing assets in current condition y Liquidation Value: amount a company can realize if it sells its assets on termination of business y Going concern Value: amount a company can realize if it sells its business as an operating one; normally this value is higher than liquidation value y Market Value: current price at which the security is being bought/ sold in the market
y

Bonds Values and Yields

1. 2. 3.

Bonds with maturity Pure discount bonds Perpetual bonds

Valuation of Bond y Bonds (secured debt) are negotiable promissory notes issued by corporate/ govt. agencies; carry a specific rate of interest paid periodically; are redeemable after a specific period
y

Face Value: stated on the face of the bond, also called par value: represents amount of borrowing by the firm y Coupon rate of interest: thus, interest amount payable on a bond is interest rate * face value
y

Maturity period: repaid on maturity, specific time period for which it is issued y Redemption Value: may be at par/ premium or discount y Market Value: at which it is traded on stock exchange y Issue Price: may be at par, premium or discount
y

(i) Bonds with a Maturity Period Value of the Bond is determined as Follows,
y

Vd =

I1 + I2 + .. In + MV (1+Kd)1 (1+Kd)2 (1+Kd)n (1+Kd)n

I1,I2 = Annual Interest for year 1, year 2 and so on MV = Maturity value or Redemption value K d = Required rate of return

Example : A bond whose par value is Rs. 1,000 bears a coupon rate of 12% and a maturity period of 3 years. The required rate of return on the bonds is 10%. What is the value of the bond?

Answer : Rs. 1,049.73

omework:

(ii) Bonds Redeemable in Installments Vd = CF1 + CF2 + + CFn (1+Kd)1 (1+Kd)2 (1+Kd)n
CF = Cash Inflow year 1, year 2 and so on Kd = Required rate of return Cash inflow includes payment towards principal and interest

Example: Air India has issued 5 year 8% bonds of Rs.1,000 each. The bond amount will be amortized equally over its life. Ram, an investor, requires a return of 7%. At what price should he buy the bond?

Answer : R s. 1,025.69

Homework

(iii) Perpetual Bonds They never mature for payment and there is no maturity value

Vd = I Kd

= Annual Interest The required rate of return

Example : Mr. A has a perpetual bond of Rs. 1,000. He receives an interest rate of Rs. 90 annually. What is the value of the bond, if the required rate of return is 10% Answer: Rs. 900

(iv) Valuation of Bonds, with Half-yearly Interest

y y

Annual Interest is to be divided by 2 to get halfyearly interest (I/2) The maturity period is to be multiplied by 2 to get the number of half yearly periods (if 6 yrs, 6/2 = 12 half yearly periods) Required rate of return (kd) is to be divided by 2 to get the appropriate discount rate for half period (if kd = 12%, 12/2 = 6% = 0.06)

Vd = I1 + I2 + .. In + MV (1+Kd)1 (1+Kd)2 (1+Kd)n (1+Kd)n

Example :
Mr. Dev holds bonds of the face value of Rs. 1,000 which carry a coupon rate of 10% p.a. Interest is payable half yearly. The required rate of return is 12% p.a. Calculate the value of the bond if the bonds are redeemable after two years.

Answer: Rs. 965.24

(v) Bond Yield measures  Yield signifies the return earned on an investment.  Bond yield is the rate of return earned on the debentures.  Yield can be measured by the following methods  Yield to Maturity Yield to call Current Yield

(a) Yield to Maturity (YTM)

y

(i) Redeemable Bonds YTM is the rate of return earned by an investor who purchases a bond and holds it till maturity. It is the rate at which present value of inflows (interest and Maturity value) is equal to the present value of Outflow (Purchase price) the value of Kd is to be calculated by trial and error method

Example :
Face Value of 8% Bond Rs. 1,000 Current market price Rs. 850 Maturity period 9 years Calculate YTM

P.V of Interest @ 12%

P.V of Interest @ 10% 1/1.10 0.909*1/1.10 0.826*1/1.10 0.751*1/1.10 0.683*1/1.10 0.621 *1/1.10 0.564 *1/1.10 0.513 *1/1.10 0.467 *1/1.10 TOTAL 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 5.758

1/1.12 0.893 * 1/1.12 0.797 * 1/1.12 0.712 * 1/1.12 0.636 * 1/1.12 0.567 * 1/1.12 0.507*1/1.12 0.452* 1/1.12

0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404

0.404 * 1/1.12 0.361 TOTAL 5.329

Assuming the rate of 12% P.V of Interest @ 12% = 5.329*80 = 426.32 P.V of Maturity value @ 12% = 0.361*1000 = 361 P.V of cash inflows @12% = 787.32 Assuming the rate of 10% P.V of Interest @ 10% = 5.758*80 = 460.64 P.V of Maturity value @ 10% = 0.424*1000 = 424 P.V of cash inflows @10% = 884.64 The rate lies between 10% and 12%

For a difference of 97.32 (884.64-787.32) the difference in rates is = 2% (12-10) For a difference of 34.64 (884.64-850), the difference in rates is,

x2/97.32*34.64 = 0.71 xYTM = 10+0.71 = 10.71% OR x2/97.32*62.68 = 1.288 xYTM = 12-1.29 = 10.71 %

Appropriate YTM
YTM = Annual return = I +(MV-PP)/n Average Value (MV+PP)/2

Example: Zion Industries Ltd. has issued bonds of the face value of Rs.500.The coupon rate is 12% and the bonds are redeemable after 5 years. Current market price is Rs. 435. Calculate approximate YTM. Answer : 15.61%

(ii) YTM of perpetual Bonds YTM = Annual Interest Current Market Price Example The coupon rate of interest on a Rs.1,000 par value perpetual bond is 8% and the current market price isRs.800. What is the YTM? Answer: .10 or 10%

(b) Yield to Call y Yield to Call is exactly similar to YTM, but here yield is found till the call of the bond. y Some corporate issues bonds with call feature, that allows the company call back the bond before maturity period. Example; Sham Ltd. issues 10 per cent callable bonds with a face value of Rs. 1,000. The bond is currently selling of Rs. 1,100. Maturity period is 10 years. Determine YTC assuming company calls (buy Back) bonds after 5 years because interest rate fallen by 2 per cent at Rs. 1,000.

P.V of Interest @ 5% for 5 Yrs

P.V of Interest @ 10% for 5 yrs

1/1.05 0.952 * 1/1.05 0.907*1/1.05 0.864*1/1.05 0.823*1/1.05

0.952 0.907 0.864 0.823 0.784

1/1.10 0.909 * 1/1.10 0.826*1/1.10 0.751 * 1/1.10 0.683 * 1/1.10

0.909 0.826 0.751 0.683 0.621

TOTAL

4.33

TOTAL

3.790

P. V of Interest @ 10% for 5 yrs = 100*3.790 = 379.00 (1000*10/100= 100) P.V of Maturity value @10% = 1000*0.621 P.V of cash inflows @10% (-) Current Price = 621.00 = 1000 = 1100 (-) 100

P. V of Interest @ 5% for 5 yrs = 100*4.33 (1000*10/100= 100) P.V of Maturity value @5% = 1000*0.784 P.V of cash inflows @5% (-) Current Price

= 433.00

= 784.00 = 1217 = 1100 117

YTC = 5% + (10%-5%) * Rs. 1,217 Rs. 1,100 Rs. 1,217 Rs. 1,000

= 5% + 5*117 217 = 5% + 2.70 = 7.70%

(c) Current Yield Current Yield = Annual Interest Current Market Price Example; Shalom Ltd. issued 12% debentures of Rs.1,000. The current market price of the debentures is Rs. 750. Calculate (a) the yield to an investor who had purchased the debentures at Rs. 1,000 (Answer:12% on 1000 = 120) (b) the current yield (Answer: 0.16 or 16%)

Valuation of Shares
y

A company may issue two types of shares:

ordinary shares and preference shares  Owners of shares are called Shareholders  the capital contributed by them is called Share Capital

Features of Preference and Ordinary Shares

Claims Dividend Redemption Conversion

Features
1. Claims

Preference Shares
Have claim on assets and income prior to ordinary shareholders -Fixed - if cumulative rights, dividend will accumulate until paid off -Redeemable maturity date -Irredeemable- perpetual

Equity Shares
Have residual (leftover) claim on companys income - Dividend rate is not known - Will not accumulate No Maturity date

2. Dividend

3. Redemption

Convertible preference shares can be converted 4. Conversion into ordinary shares after a stated period

Equity shares cannot be converted

Valuation of Preference Shares Vp = P.D1 + P.D2 + P.Dn + MVn (1+Kp)1 (1+Kp)2 (1+Kp)n (1+Kp)n Example: Mr. Kumar is considering the purchase of a 7% preference share of Rs.1,000 redeemable after 5 yrs, at par. Required rate of return is 9 %. Is it advisable to buy the preference share at Rs. 900? Answer : Rs. 922.05

Value of Perpetual Preference Shares

Vp = P.D K

= Preference Dividend Required rate of return

Example: Mr. Alex holds 9% irredeemable preference shares of Rs. 1000. The required rate of return is 12%. What is the value of the preference Shares? Answer : (90/.12= Rs. 750)

Valuation of Ordinary Shares y The valuation of ordinary or equity shares is relatively more difficult. The rate of dividend on equity shares is not known; also, the payment of equity dividend is discretionary (optional or flexible). The earnings and dividends on equity shares are generally expected to grow, unlike the interest on bonds and preference dividend. Methods of Valuation 1. Dividend Capitalization Approach 2. Earnings Capitalization Approach

1.

Dividend Capitalization Approach

 Single period Valuation Approach  Multi period valuation  When there is no growth  When there is growth  Normal Growth  Super Normal Growth

(a) Single period Valuation Approach Here, the investor holds the shares for one year, expects to receive the dividend and sell the shares at the end of the year.

P0 = D1 +P1 1+Ke
P0 = Current price (value) of equity share D1 = Expected Dividend P1 = Expected Sale price Ke = Required rate of return

Example: Jo Ltd. Is expected to declare a dividend of Rs.4 per share and reach a price of Rs.220 after one from now. Calculate the value (Po) of the share, if the required rate of return is 12%. Answer : Rs. 200

(b) Multi-period Valuation Here, the investor holds the shares for two years or more and sells it.

P0 =

D1 + D2 + ..+ Dn (1+Ke)1 (1+Ke)2 (1+Ke)n

Pn (1+Ke)n

P0 = Current price (or value) of equity share D1 = Expected Dividend for year1,2,3 Pn = Expected Sale price at the end of year n Ke = Required rate of return

Example: Mr. A wants to buy an equity share and sell it after 2 years. The expected dividends at the end of the first year and second year are Rs.3 and Rs. 4. The expected sale price of the share is Rs. 250. calculate the current price of the share, taking the required rate of return as 15%. Answer : Rs. 194.74

(c) When there is no growth when the dividend per share remains constant (there is no growth in dividends), the value of share can be found as follows, P0 = D Ke Where, P0 = Value of the share D = Dividend Ke = Required rate of return

Example: Mahindra Ltd. is currently paying a dividend of Rs.6 per share. It is not expected to change the dividend in future. Calculate the value of the share if the required rate of return is 12%.

Answer : Rs. 50

(d) Growth in Dividends Normal Growth If the dividends of a firm are expected to grow at a constant rate, the value of the share (P0) is calculated as follows, D1 = D0 (1+g) ke g ke - g Where, P0 = Value of the share D0 = Current Dividend D1 = Expected Dividend Ke = Required rate of return g = Expected growth rate P0 =

Example:
Jit ltd. is expected to pay a dividend of Rs. 5 per share next year. The dividend is expected to grow perpetually at the rate of 10%.

Answer : Rs. 100

(e) Super Normal Growth During times of prosperity a firm may earn very high profits. As a result, dividends may also increase at a super normal growth rate. After some years, the super normal growth may not continue and the firm may experience a normal growth. The value of the share may found through the following steps

1. Calculate the expected dividends 2. Find out the present value of expected dividends, (A) 3. Find out the value of the share at the end of the super normal growth period. For this valuation, apply the normal growth rate and required rate of return. Formula: D1 Ke - g D1 = Expected dividend Ke = Capitalization Rate g = normal growth rate

4. The value arrived in step 3 is the future value (say value at the end of 5 yrs/ 6 year or so). Hence, find out its present value by discounting. (B) 5. Value of the share = (A+B) = P.V of expected dividends +P.V. of share value at the end of super normal growth period. Example: Skyrocket Ltd is currently paying a dividend of Rs.3 per share. The dividend is expected to grow at 25% annually for 5 yrs and then at 7% for ever. What is the present value of the share if the capitalization rate is 14%

(1)

Calculation of expected dividends Current year dividend = D0 = Rs.3 Expected dividend for 5 yrs. Growth rate = 25% D1 D2 D3 D4 D5
D0 (1+g) D1 (1+g) D2 (1+g) D3 (1+g) D4 (1+g)

3*1.25 3.75*1.25 4.69*1.25 5.86*1.25 7.33*1.25

3.75 4.69 5.86 7.33 9.16

(2) Present value of expected dividends

Year Exp. Div 1 2 3 4 5 3.75 4.69 5.86 7.33 9.16

P.V. Factor P.V of Dividends @14% 1/1.14 = 0.877 3.29 0.769 3.61 0.675 3.96 0.592 4.34 0.519 4.75 19.95

Present Value of Expected dividends (A)

(3) Value of the share at the end of super normal growth period, Value of the share at the end of 5 yrs, D6 Ke g Expected dividend (D6) Dividend of the 5th year = Rs.9.15 Exp. Div of the 6th year = 9.15*(1.07) = Rs. 9.79 Ke = 14 %, g = 7% = .07 Value of the share P5 = 9.79 = Rs. 139.86 .14-.07
As the super normal growth period is over, normal growth rate is applied

P5 =

(4) Present Value Value of the share at the end of 5 years = Rs. 139.85 Its present value at a discount rate of 14% P.V of Re.1 receivable after 5 years at 14% = 0.519 P.V of Rs. 139.85 = 0.519*139.85 = Rs. 72.58 (B)

(5) Value of the share 19.95+72.58 = Rs. 92.53

2. Earnings Capitalization Approach Earnings (instead of dividend) may also be capitalized to determine the value of the shares EPS, also known as Earnings per share, is the companies income divided by the number of shares outstanding. This can also be broken down into diluted EPS, which is usually better for analysis. A dividend is the money that the company actually distributed to its shareholders. There can be, and usually is a difference between EPS and dividends.

(i)

When the payout is 100%: that is, when the firm distributes all the profits without any retention, earnings (EPS) are equal to the dividend

(ii) When the firm does not have any growth opportunities and the firms equity (ROE) is equal to the capitalization rate (Ke)
Value of a share (P0) under the model is determined as follows,

P0 = EPS = Expected Earnings Per Share ke Capitalization Rate

Example: (Where payout is 100%) Calculate the price of an equity share according to earnings capitalization approach, assuming a payout of 100% EPS = Rs. 10, Capitalization rate = 20% Answer: Rs. 50

Example: (Where r = Ke) Calculate the price of an equity share from the following date Earnings per share (EPS) = Rs. 30 Internal rate of return (r) = 20% Equity capitalization rate (Ke) = 20% Answer: Rs. 150

Return on Equity shares An investor may be interested in finding out the return he can expect from his investment in equity shares. The expected rate of return with reference to a holding period of one year can be calculated as follows, The expected return consists of expected dividend and expected capital gain.

Expected rate of return = Expected Div + Exp capital gain Purchase Price = D1 + (P1 P0) P0 D1 = Expected Div P1 P0 = Capital Gain P1 = Expected Selling price P0 = Purchase price or current market price

Example: A companys share is currently selling at Rs. 50 per share. It is expected that a dividend of Rs. 3 per share and a price of Rs. 52 will be obtained at the end of one year. Calculate the expected rate of return.

Answer: .10 = 10%

Return on Equity when growth rate is given Suppose, the investor prefers to hold the shares for a long period (say infinity) and the dividends are expected to grow at a compound annual rate indefinitely, expected return on equity shares calculated as follows, Re = Exp Dividend + Growth rate Current Price

Example: The current price of a companys share is Rs. 70. The company is expected to pay a dividend of Rs. 4.20 per share, with an annual growth rate of 9%. Calculate the return on equity.

Answer: .15 = 15%

Valuation of Warrants A financial is a financial instrument by a company. It gives the holder the right to buy a fixed number of shares at a fixed price, during a specified period of time. Warrants are issued free of cost along with an issue of equity shares, debentures, convertible debentures, preference shares etc. The warrants enable the holders to get the shares at a price which is significantly lower than the market price. This makes the new issue more attractive to investors.

When issued, the warrant has no value. However, when the price of the share (which the warrant holder has the right to buy) increases, the value of the warrant also increases. The theoretical value of a warrant can be found as follows,
Value of the warrant = (Market price Offer price) No. of shares

Example: The current market price of an equity share of J Ltd is Rs. 200. The investors holding the warrant is given the right to buy 3 shares at a price of Rs.120 per share. Calculate the value of the warrant.

Answer: Rs. 240

Answer: The warrant holder is entitled to buy 3 shares at a price of Rs. 120 Market Value (3*200) = 600 Less: Price at which investor can get the shares( 3*120) = 360 Value of the Warrant = 240 OR Value of the warrant = (Market price Offer price) * No. of shares = (200-120)3 = Rs. 240

Option Valuation

An option is a contract to buy or sell a specific financial product officially known as the option's underlying instrument or underlying interest. For equity options, the underlying instrument is a stock, exchange-traded fund (ETF), or similar product. The contract itself is very precise. It establishes a specific price, called the strike price, at which the contract may be exercised, or acted on. And it has an expiration date. When an option expires, it no longer has value and no longer exists.