Session # 2 Securities and their valuation Bonds Stocks

Valuation- Art or science or both ??

CFO of an ABC cement manufacturing company wanted to sell stock in his company, want financing for installing an alternative energy plant. After many experiments CFO found it tough predicting how much investors would be willing to pay for the stock in his company. Those who invest in securities use all types of techniques to value the stock they purchase. They assess all risk related to the company, pore on financial data, compare the P/E ratio of the company with the industry. ABC company as a stock issuer quickly learned that arriving at present value for stock was darned near impossible.

Valuation- Art or science or both ??

He then started through the easy steps; figured out first how much his company was worth by comparing his company with other cement manufacturing companies listed on the exchange. He discovered that they are generally valued at 7x their earnings. So CFO figured out that if his company earns PKR 1 million he would be able to raise PKR 7 million in long term funds by selling stocks to investors.

Valuation- Art or science or both ??

Are investors willing to rely on P/E ratio for cement sector ??? A new company on bloc people would look for other inherent risk factors??? For new company stock offering the company must be undervalued so that if investors thought that company is worth rupees PKR 7 million they would only be willing to invest PKR 5 million.

General Valuation Points to consider

The value of security depends on the future earning power. To value the security we consider three factors Size of cash flow Timing of cash flow risk

Bonds

Who issues bond Govt, Corporate, Municipal, Foreign bonds. Key characteristics of bond- par value, Coupon interest rate, maturity date, provision to call or redeem bonds, sinking funds.

Bonds Valuation
Discounted Cash flow model (DCF)
A DCF model values a security by calculating the sum of present values of all expected future cash flows. Each cash flow is discounted back the appropriate number of periods according to its expected timing and RRR. The discount rate is the investors RRR which is the function of risk of the investment. The riskier the security the higher the RRR.

Bonds Valuation
Discounted Cash flow model (DCF)
Formula = CF1 / (1+k)^1 + CF2 / (1+k)^2 + + CFn / (1+k)^n V(bond) = Coupon * [ (1 1 / (1+k)^n) / k] + M / (1+k)^n

Bonds Valuation
Yield To Maturity (YTM)
YTM represents the average rate of return on a bond if all promised interest and principal payments are made on time and if the interest payments are reinvested at the YTM rate given the price paid for the bond. How to calculate YTM ? The relationship b/w Bond price and YTM: bonds market price depends on its YTM. When YTM is higher than the coupon rate the bonds sells at the discount from its face value Premium or market price equals face value ???

Preferred Stock Valuation

Preferred stocks has no maturity date so it has no maturity value. Its future cash payments are dividend payments that are paid at regular interval for as long as they own the stock. Formula : V (stock) = Dividend / RRR

Common Stock Valuation

Common stock represents ownership interest in a corporation and is characterized by two features: Dividends and Capital Gain. Going concern Valuation Model Constant Growth Dividend Model No Growth Dividend Model Non Constant Growth Model