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SHARES

Principle underlying valuation:

Value of any asset is the discounted value

of the future steams of benefit expected

from the asset.

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

• Book Value

• Replacement Value

• Liquidation Value

• Going Concern Value

• Market Value

Features of a Bond

• Face Value

• Interest Rate—fixed or floating

• Maturity

• Redemption value

• Market Value

Bonds Values and Yields

• Bonds with maturity

• Pure discount bonds

• Perpetual bonds

Bond with Maturity

Bond value = Present value of interest +

Present value of maturity value:

0

1

INT

(1 ) (1 )

n

t n

t n

t

d d

B

B

k k

=

= +

+ +

¿

Yield to Maturity

• The yield-to-maturity (YTM) is the measure of

a bond’s rate of return that considers both the

interest income and any capital gain or loss.

YTM is bond’s internal rate of return.

• YTM of a bond with maturity:

• A perpetual bond’s yield-to-maturity:

0

1

INT INT

(1 )

n

t

t

d d

B

k k

=·

=

= =

+

¿

Current Yield

• Current yield is the annual interest divided

by the bond’s current/market value.

• Example: The annual interest is Rs 60 on

the current investment of Rs 883.40.

Therefore, the current rate of return or the

current yield is: 60/883.40 = 6.8 per cent.

• Current yield does not account for the

capital gain or loss.

Yield to Call

• Yield to call is the return associated with the

bonds with buy back or call provision when the

call option is exercised before maturity.

• Example: Suppose the 10% 10-year Rs 1,000

bond is redeemable (callable) in 5 years at a call

price of Rs 1,050. The bond is currently selling

for Rs 950.The bond’s yield to call is 12.7%.

( ) ( )

5

5

1

100 1, 050

950

1 YTC 1 YTC

t

t =

= +

+ +

¿

Bond Value and Amortisation of

Principal

• A bond (debenture) may be amortised every

year, i.e., repayment of principal every year

rather at maturity.

• The formula for determining the value of a bond

or debenture that is amortised every year, can

be written as follows:

– Note that cash flow, CF, includes both the interest and

repayment of the principal.

0

1

(1 )

n

t

t

t

d

CF

B

k

=

=

+

¿

Pure Discount Bonds

• Pure discount bonds are called deep-discount

bonds or zero-interest bonds or zero-

coupon bonds.

• The market interest rate, also called the

market yield, is used as the discount rate.

• Value of a pure discount bond = PV of the

amount on maturity:

( )

0

1

n

n

d

M

B

k

=

+

Pure Discount Bonds

Example: A company may issue a pure

discount bond of Rs 1,000 face value for

Rs 520 today for a period of five years.

The rate of interest can be calculated as

follows:

( )

( )

5

5

1/ 5

1, 000

520

1 YTM

1, 000

1 YTM 1.9231

520

1.9231 1 0.14 or 14% i

=

+

+ = =

= ÷ =

Perpetual Bonds

Perpetual bonds, also called consols, has

an indefinite life and therefore, it has no

maturity value. Perpetual bonds or

debentures are rarely found in practice.

Perpetual Bonds

• Suppose that a 10 per cent Rs 1,000

bond will pay Rs 100 annual interest into

perpetuity. What would be its value of the

bond if the market yield or interest rate

were 15 per cent?

• The value of the bond is determined as

follows:

0

INT 100

Rs 667

0.15

d

B

k

= = =

Bond Values and Changes in

Interest Rates

• The value of the bond declines as the market interest rate (discount

rate) increases.

• The value of a 10-year, 12 per cent Rs 1,000 bond for the market

interest rates ranging from 0 per cent to 30 per cent.

0.0

200.0

400.0

600.0

800.0

1000.0

1200.0

0% 5% 10% 15% 20% 25% 30%

Interest Rate

B

o

n

d

V

a

l

u

e

Bond Maturity and Interest Rate

Risk

• The intensity of interest rate

risk would be higher on

bonds with long maturities

than bonds with short

maturities.

• The differential value

response to interest rates

changes between short and

long-term bonds will always

be true. Thus, two bonds of

same quality (in terms of the

risk of default) would have

different exposure to interest

rate risk.

Present Value (Rs)

Discount rate (%) 5-Year bond 10-Year bond

Perpetual bond

5 1,216 1,386 2,000

10 1,000 1,000 1,000

15 832 749 667

20 701 581 500

25 597 464 400

30 513 382 333

Bond Maturity and Interest Rate

Risk

Bond Duration

In finance, the duration of a financial asset measures the

sensitivity of the asset's price to interest rate

movements. Duration is a measurement of how long, in

years, it takes for the price of a bond to be repaid (i.e.

recovery of PV of cash flows) by its internal cash flows. It

is an important measure for investors to consider, as

bonds with higher durations carry more risk and have

higher price volatility than bonds with lower durations.

The units of duration are years, and duration is always between 0

years and the time to maturity of the bond, with duration equal to

time to maturity if and only if the bond is a zero-coupon bond.

Macaulay duration

Macaulay duration, named for Frederick

Macaulay who introduced the concept, is the

weighted average maturity of a bond where the

weights are the relative discounted cash flows in

each period.

Macaulay Duration (D) =

Σ (cash flow discounted with YTM X time to CF)

Price of the bond

Duration of Bonds

Let us consider the

8.5 per cent rate

bond of Rs 1,000

face value that has a

current market value

of Rs 954.74 and a

YTM of 10 per cent,

and the 11.5 per cent

rate bond of Rs 1,000

face value has a

current market value

of Rs 1,044.57 and a

yield to maturity of

10.6 per cent. Table

shows the calculation

of duration for the

two bonds.

8.5 Percent Bond

Year Cash Flow

Present

Value

at 10 %

Proportion

of

Bond Price

Proportion

of

Bond Price

x Time

1 85 77.27 0.082 0.082

2 85 70.25 0.074 0.149

3 85 63.86 0.068 0.203

4 85 58.06 0.062 0.246

5 1,085 673.70 0.714 3.572

943.14 1.000 4.252

11.5 Percent Bond

Year

Cash

Flow

Present

Value

at 10.6%

Proportion

of

Bond Price

Proportion

of Bond

Price x

Time

1 115 103.98 0.101 0.101

2 115 94.01 0.091 0.182

3 115 85.00 0.082 0.247

4 115 76.86 0.074 0.297

5 1,115 673.75 0.652 3.259

1,033.60 1.000 4.086

Volatility

The volatility or the interest rate sensitivity of a bond is

given by its duration and YTM. A bond’s volatility,

referred to as its modified duration, is given as

follows:

The volatilities of the 8.5 per cent and 11.5 per cent

bonds are as follows:

If YTM increases by 1%, this will result in 3.87% decrease in the

price of the 8.5% bond and a 3.69% decrease in the price of 11.5%

bond.

Duration

Volatility of a bond

(1 YTM)

=

+

4.252

Volatility of 8.5% bond 3.87

(1.100)

= =

4.086

Volatility of 11.5% bond 3.69

(1.106)

= =

Valuation of Shares

• A company may issue two types of shares:

– ordinary shares and

– preference shares

• Features of Preference and Ordinary

Shares

– Claims

– Dividend

– Redemption

– Conversion

Valuation of Preference Shares

• The value of the preference share would be the

sum of the present values of dividends and the

redemption value.

• A formula similar to the valuation of bond can be

used to value preference shares with a maturity

period:

1

0

1

PDIV

(1 ) (1 )

n

n

t n

t

p p

P

P

k k

=

= +

+ +

¿

Value of a Preference Share-

Example

Suppose an investor is considering the purchase of a 12-year, 10% Rs 100 par

value preference share. The redemption value of the preference share on maturity

is Rs 120. The investor’s required rate of return is 10.5 percent. What should she

be willing to pay for the share now? The investor would expect to receive Rs 10

as preference dividend each year for 12 years and Rs 110 on maturity (i.e., at the

end of 12 years). We can use the present value annuity factor to value the

constant stream of preference dividends and the present value factor to value the

redemption payment.

30 . 101 Rs 24 . 36 06 . 65 302 . 0 120 506 . 6 10

) 105 . 1 (

120

) 105 . 1 ( 105 . 0

1

105 . 0

1

10 P

12 12

0

= + = × + × =

+

(

(

¸

(

¸

×

÷ × =

Note that the present value of Rs 101.30 is a composite of the present value of

dividends, Rs 65.06 and the present value of the redemption value, Rs 36.24.The

Rs 100 preference share is worth Rs 101.3 today at 10.5 percent required rate of

return. The investor would be better off by purchasing the share for Rs 100 today.

Valuation of Ordinary Shares

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.

– The earnings and dividends on equity shares are

generally expected to grow, unlike the interest on

bonds and preference dividend.

Dividend Capitalisation

• The value of an ordinary share is determined by

capitalising the future dividend stream at the

opportunity cost of capital

• Single Period Valuation:

– If the share price is expected to grow at g per cent, then

P

1

= P

o

(1 + g) &

– P

o

= (DIV

1

+ P

1

)/(1 + k

e

)

– We obtain a simple formula for the share valuation as

follows:

1

0

DIV

e

P

k g

=

÷

Multi-period Valuation

• If the final period is n, we can write the general

formula for share value as follows:

• Growth in Dividends

– Normal Growth

– Super-normal Growth

0

1

DIV

(1 ) (1 )

n

t n

t n

t

e e

P

P

k k

=

= +

+ +

¿

Growth = Retention ratio Return on equity

ROE g b

×

= ×

1

0

DIV

e

P

k g

=

÷

Share value PV of dividends during finite super-normal growth period

PV of dividends during indefinite normal growth period

=

+

Earnings Capitalisation

Under two cases, the value of the share

can be determined by capitalising the

expected earnings:

– When the firm pays out 100 per cent dividends;

that is, it does not retain any earnings.

– When the firm’s return on equity (ROE) is equal

to its opportunity cost of capital.

Equity Capitalisation Rate

For firms for which dividends are expected

to grow at a constant rate indefinitely and

the current market price is given

1

0

DIV

e

k g

P

= +

Caution in Using Constant-Growth

Formula

• Estimation errors

• Unsustainable high current growth

• Errors in forecasting dividends

Valuing Growth Opportunities

The value of a growth opportunity is given

as follows:

1

1

NPV

EPS (ROE )

( )

g

e

e

e e

V

k g

b k

k k g

=

÷

× ÷

=

÷

Price-Earnings (P/E) Ratio: How

Significant?

• P/E ratio is calculated as the price of a

share divided by earning per share.

• Some people use P/E multiplier to value

the shares of companies.

• Alternatively, you could find the share

value by dividing EPS by E/P ratio, which

is the reciprocal of P/E ratio.

Price-Earnings (P/E) Ratio: How

Significant?

• The share price is also given by the

following formula:

• The earnings price ratio can be

derived as follows:

1

0

EPS

g

e

P V

k

= +

1

EPS

1

g

e

o o

V

k

P P

(

= ÷

(

¸ ¸

Price-Earnings (P/E) Ratio: How

Significant?

Cautions:

– E/P ratio will be equal to the capitalisation rate

only if the value of growth opportunities is zero.

– A high P/E ratio is considered good but it could

be high not because the share price is high but

because the earnings per share are quite low.

– The interpretation of P/E ratio becomes

meaningless because of the measurement

problems of EPS.

to get a copy of this presentation visit

www.slideshare.net/jairajgupta

by

jairaj gupta

e-mail: jairajgupta@aol.com

mobile: (91) 9007202650

**Principle underlying valuation:
**

Value of any asset is the discounted value of the future steams of benefit expected from the asset.

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 • Book Value • Replacement Value • Liquidation Value • Going Concern Value • Market Value .

Features of a Bond • Face Value • Interest Rate—fixed or floating • Maturity • Redemption value • Market Value .

Bonds Values and Yields • Bonds with maturity • Pure discount bonds • Perpetual bonds .

Bond with Maturity Bond value = Present value of interest + Present value of maturity value: B0 t 1 n INTt Bn (1 kd )t (1 kd ) n .

Yield to Maturity • The yield-to-maturity (YTM) is the measure of a bond’s rate of return that considers both the interest income and any capital gain or loss. YTM is bond’s internal rate of return. • YTM of a bond with maturity: • A perpetual bond’s yield-to-maturity: B0 t 1 n INT INT (1 kd )t kd .

40. • Current yield does not account for the capital gain or loss.40 = 6.8 per cent. . Therefore.Current Yield • Current yield is the annual interest divided by the bond’s current/market value. • Example: The annual interest is Rs 60 on the current investment of Rs 883. the current rate of return or the current yield is: 60/883.

050 1 YTC 5 .000 bond is redeemable (callable) in 5 years at a call price of Rs 1.Yield to Call • Yield to call is the return associated with the bonds with buy back or call provision when the call option is exercised before maturity. 950 t 1 5 100 1 YTC t 1.The bond’s yield to call is 12. • Example: Suppose the 10% 10-year Rs 1.050.7%. The bond is currently selling for Rs 950.

Bond Value and Amortisation of Principal • A bond (debenture) may be amortised every year. CF. i. . can be written as follows: B0 CFt (1 kd )t t 1 n – Note that cash flow. • The formula for determining the value of a bond or debenture that is amortised every year. includes both the interest and repayment of the principal..e. repayment of principal every year rather at maturity.

• The market interest rate. • Value of a pure discount bond = PV of the amount on maturity: B0 1 kd Mn n . also called the market yield.Pure Discount Bonds • Pure discount bonds are called deep-discount bonds or zero-interest bonds or zerocoupon bonds. is used as the discount rate.

Pure Discount Bonds Example: A company may issue a pure discount bond of Rs 1.14 or 14% .92311/ 5 1 0.000 face value for Rs 520 today for a period of five years. The rate of interest can be calculated as follows: 520 5 1.9231 1 YTM 520 i 1.000 1.000 1 YTM 5 1.

Perpetual Bonds Perpetual bonds. also called consols. . has an indefinite life and therefore. Perpetual bonds or debentures are rarely found in practice. it has no maturity value.

000 bond will pay Rs 100 annual interest into perpetuity.15 .Perpetual Bonds • Suppose that a 10 per cent Rs 1. What would be its value of the bond if the market yield or interest rate were 15 per cent? • The value of the bond is determined as follows: INT 100 B0 Rs 667 kd 0.

0 0.0 200. • The value of a 10-year. 12 per cent Rs 1.0 0% 5% 10% 15% 20% 25% 30% Interest Rate .0 1000.0 400.Bond Values and Changes in Interest Rates • The value of the bond declines as the market interest rate (discount rate) increases.000 bond for the market interest rates ranging from 0 per cent to 30 per cent.0 600. 1200.0 Bond Value 800.

Thus.000 15 832 749 667 20 701 581 500 25 597 464 400 30 513 382 333 . two bonds of same quality (in terms of the risk of default) would have different exposure to interest rate risk.000 1.Bond Maturity and Interest Rate Risk • The intensity of interest rate risk would be higher on bonds with long maturities than bonds with short maturities. Present Value (Rs) Discount rate (%) 5-Year bond 10-Year bond Perpetual bond 5 1.386 2.216 1.000 10 1.000 1. • The differential value response to interest rates changes between short and long-term bonds will always be true.

Bond Maturity and Interest Rate Risk .

The units of duration are years. It is an important measure for investors to consider. and duration is always between 0 years and the time to maturity of the bond.e. Duration is a measurement of how long.Bond Duration In finance. as bonds with higher durations carry more risk and have higher price volatility than bonds with lower durations. with duration equal to time to maturity if and only if the bond is a zero-coupon bond. recovery of PV of cash flows) by its internal cash flows. . in years. the duration of a financial asset measures the sensitivity of the asset's price to interest rate movements. it takes for the price of a bond to be repaid (i.

named for Frederick Macaulay who introduced the concept. is the weighted average maturity of a bond where the weights are the relative discounted cash flows in each period.Macaulay duration Macaulay duration. Σ (cash flow discounted with YTM X time to CF) Macaulay Duration (D) = Price of the bond .

000 face value that has a current market value of Rs 954.06 0.5 per cent rate bond of Rs 1.25 0.149 85 63.Duration of Bonds 8.5 Percent Bond Proportion Present Proportion of Bond Cash Value of Price x at 10.115 673.86 0.86 0.082 0.068 0.57 and a yield to maturity of 10.000 face value has a current market value of Rs 1. Year 1 2 3 4 5 Year 1 2 3 4 5 Proportion Present Proportion of Value of Bond Price Cash Flow at 10 % Bond Price x Time 85 77.714 3.101 115 94.6 per cent.085 673.203 85 58.00 0.74 and a YTM of 10 per cent.01 0.297 1.6% Bond Price Time Flow 115 103.652 3.082 85 70.101 0.246 1.182 115 85.000 4.074 0.75 0.27 0.252 11.082 0.14 1.572 943.062 0. and the 11.074 0.60 1.000 4.044. Table shows the calculation of duration for the two bonds.086 .259 1.70 0.091 0.247 115 76.98 0.5 Percent Bond Let us consider the 8.033.5 per cent rate bond of Rs 1.

this will result in 3. is given as follows: Duration Volatility of a bond (1 YTM) The volatilities of the 8.5 per cent bonds are as follows: Volatility of 8. . A bond’s volatility.106) If YTM increases by 1%.Volatility The volatility or the interest rate sensitivity of a bond is given by its duration and YTM.5 per cent and 11.87 (1.69% decrease in the price of 11.5% bond.5% bond and a 3.69 (1.100) Volatility of 11.5% bond 4. referred to as its modified duration.5% bond 4.252 3.87% decrease in the price of the 8.086 3.

Valuation of Shares • A company may issue two types of shares: – ordinary shares and – preference shares • Features of Preference and Ordinary Shares – – – – Claims Dividend Redemption Conversion .

Valuation of Preference Shares • The value of the preference share would be the sum of the present values of dividends and the redemption value. • A formula similar to the valuation of bond can be used to value preference shares with a maturity period: P0 t 1 n Pn PDIV1 (1 k p )t (1 k p ) n .

The investor’s required rate of return is 10.5 percent required rate of return.06 36.506 120 0.105) (1.105 (1.105) 10 6. at the end of 12 years).302 65. What should she be willing to pay for the share now? The investor would expect to receive Rs 10 as preference dividend each year for 12 years and Rs 110 on maturity (i. 1 1 120 P0 10 12 12 0.30 Note that the present value of Rs 101.105 0. The redemption value of the preference share on maturity is Rs 120.24 Rs101.3 today at 10. 10% Rs 100 par value preference share.Value of a Preference ShareExample Suppose an investor is considering the purchase of a 12-year. Rs 65.The Rs 100 preference share is worth Rs 101.e.06 and the present value of the redemption value.. Rs 36. The investor would be better off by purchasing the share for Rs 100 today.5 percent. We can use the present value annuity factor to value the constant stream of preference dividends and the present value factor to value the redemption payment.24.30 is a composite of the present value of dividends. .

the payment of equity dividend is discretionary. – The rate of dividend on equity shares is not known. also. – The earnings and dividends on equity shares are generally expected to grow. unlike the interest on bonds and preference dividend. .Valuation of Ordinary Shares The valuation of ordinary or equity shares is relatively more difficult.

Dividend Capitalisation • The value of an ordinary share is determined by capitalising the future dividend stream at the opportunity cost of capital • Single Period Valuation: – If the share price is expected to grow at g per cent. then P1 = Po(1 + g) & – Po = (DIV1 + P1)/(1 + ke) – We obtain a simple formula for the share valuation as follows: DIV1 P0 ke g .

Multi-period Valuation • If the final period is n. we can write the general formula for share value as follows: P0 n • Growth in Dividends – Normal Growth P0 DIV1 ke g t 1 DIVt Pn (1 ke )t (1 ke )n Growth = Retention ratio Return on equity g b ROE – Super-normal Growth Share value PV of dividends during finite super-normal growth period PV of dividends during indefinite normal growth period .

that is. – When the firm’s return on equity (ROE) is equal to its opportunity cost of capital. .Earnings Capitalisation Under two cases. the value of the share can be determined by capitalising the expected earnings: – When the firm pays out 100 per cent dividends. it does not retain any earnings.

Equity Capitalisation Rate For firms for which dividends are expected to grow at a constant rate indefinitely and the current market price is given DIV1 ke g P0 .

Caution in Using Constant-Growth Formula • Estimation errors • Unsustainable high current growth • Errors in forecasting dividends .

Valuing Growth Opportunities The value of a growth opportunity is given as follows: NPV1 Vg ke g b EPS1(ROE ke ) ke ( ke g ) .

you could find the share value by dividing EPS by E/P ratio.Price-Earnings (P/E) Ratio: How Significant? • P/E ratio is calculated as the price of a share divided by earning per share. . • Alternatively. which is the reciprocal of P/E ratio. • Some people use P/E multiplier to value the shares of companies.

Price-Earnings (P/E) Ratio: How Significant? • The share price is also given by the following formula: EPS1 P0 Vg ke • The earnings price ratio can be derived as follows: Vg EPS1 ke 1 Po Po .

. – The interpretation of P/E ratio becomes meaningless because of the measurement problems of EPS.Price-Earnings (P/E) Ratio: How Significant? Cautions: – E/P ratio will be equal to the capitalisation rate only if the value of growth opportunities is zero. – A high P/E ratio is considered good but it could be high not because the share price is high but because the earnings per share are quite low.

to get a copy of this presentation visit www.slideshare.net/jairajgupta by jairaj gupta e-mail: jairajgupta@aol.com mobile: (91) 9007202650 .

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