VIDYASAGAR UNIVERSITY

DIRECTORATE OF DISTANCE
EDUCATION
MIDNAPORE-721102

M.Com.
Part – II
Paper: DCOM 201 SLM No: 054

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 VIDYASAGAR UNIVERSITY
DIRECTORATE OF DISTANCE EDUCATION
VALUATION OF SECURITIES
SLM NO - 54
PAPER CODE: DCOM 201
PAPER NAME: SECURITY ANALYSIS AND PORTFOLIO
MANAGEMENT

Structure
Objectives
Relevance of the Unit
54.1 Introduction
54.2 Valuation of Different Securities
54.2.1 Valuation of equity shares
54.2.1.1 Valuation of equity share in case of single holding period
54.2.1.2 Valuation of equity share in case of multiple holding periods (say 3 years)
54.2.1.3 Valuation of equity share in case of infinite holding period
54.2.1.4 Valuation of equity share in case of constant growth rate of dividends (under
limited holding period)
54.2.1.5 Valuation of equity share in case of constant growth rate of dividends for
infinite holding period
54.2.1.6 Valuation of equity share in case of constant dividends for infinite holding
period
54.2.1.7 Valuation of equity share in case of two-stage growth rate model
54.3 Valuation of Bonds or Debentures
54.3.1 Valuation of zero-coupon bond (ZCB)
54.3.2 Concept of yield-to-maturity
54.3.2.1 Computation of YTM
54.4 Valuation of Preference Shares
Summary
Glossary
Self-assessment Questions
References

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Objectives
After studying this unit the learners will be able to:
• Understand the various aspects relating to the valuation of equity shares.
• Understanding the valuation of bonds and preference shares.

Relevance of the Unit

This unit will be highly relevant and useful for the students of commerce education. The unit
attempts to provide easy but comprehensive understanding on the valuation of equity &
preference shares and debentures. The knowledge and understanding that the students would
gain from this unit will be highly useful and relevant for their academic development and
practical field of work in the area of security analysis.

54.1 Introduction
In portfolio management, this concept of valuation holds tremendous relevance. If we look into
the topic portfolio management, we find that before portfolio management, we have security
analysis which comes in logically. This is because, in creating a portfolio, the first task is to
identify securities for purchase and sales and then to decide whether to purchase or sale at the
given price (market rate or trading price) or to wait and then transact later on. In such a bid to
take an appropriate decision, the concept of valuation comes into the picture. By valuation, we
mean application of some technique to determine the ‘should be price’ of a security. In other
words, we need to understand that rarely we find the market price to be the same as the ‘should
be price’. This ‘should be price’ is known as intrinsic value (in the parlance of investment
management). This topic of valuation aims to teach the different techniques to compute the
intrinsic value.

The need to do valuation can be explained with the help of a simple example. Suppose, you are
walking down Esplanade which is a very popular place in Kolkata for doing street shopping.
When you are strolling in the area, you find a watch displayed, the price of which is displayed as
Rs 500. Since, you are interested in buying, you look for a while and query about the price
again. When you find the reply mentioning the same price, you ask whether it can be given at Rs.
350. You continue to negotiate and finally purchase at Rs. 400. In this process, this value of Rs.
400 assigned to the watch by the person is the valuation that is done mentally. If the offer price
would be more than Rs. 400, you would not have bought the watch. Had it been settled for Rs.
380 (say), you would have definitely purchased without much negotiation as it is less than your
valuation. Thus, from this example, it might be clear that valuation concept assists people in
arriving at decisions.

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Application of valuation

In investment management, the concept of valuation is very useful. For investors, this is
necessary because only after knowing the intrinsic value (IV) and comparing it with the
market/traded price (TP), it is possible to decide whether to purchase or sale. The decision-
making is done in the following way.

Sl. no. Situation Decision

1. MP > IV (i) Sell if you have

(ii) Do not buy at the given price
2. MP < IV (i) Buy as it is selling at a lower rate
(ii) Do not sell at the given market rate
3. MP = IV Indifferent to buying or selling

The above table helps to understand the importance of the valuation concept. Due to this, efforts
are made by financial experts to do a valuation of different securities.

54.2 Valuation of Different Securities

As mentioned in the last section about the importance of valuation, we shall discuss the valuation
of the following securities:
(i) Equity share
(ii) Preference share
(iii)Debenture
In this section, we come to the main issue of valuation and elaborate the way of valuing
securities. In this context, it is interesting to know that the basic concept of valuing securities is
the same. As per the concept, the intrinsic value of any security is the sum total of the present
value of cash flows that is generated at different points in time. An example will make the
concept clear. Suppose there is security Y which is expected to generate cash flows of C1, C2,
C3, C4 and so on in periods one, two, three and four respectively. If the minimum return
expected by the holders of the security is r %, the intrinsic value of Y (denoted by PY) will be as
follows:

PY = C1 / (1+r) + C2 / (1+r) 2 + C3 / (1+r) 3 + C4 / (1+r) 4 which is the sum total of the present
value of cash flows arising from holding the security. This concept of valuation can be extended
any number of time periods and any number of cash flows. However, for cash flows extending to
infinity (theoretically), we have mathematical techniques to reduce the formula to a simpler
form.

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Of all the securities that we will try to value, the valuation of equity is the most difficult because
of the uncertainty in respect of dividend (which is not to be paid mandatorily) and also the price
at the end of the valuation period.

Check your progress

Q1. What is the need for valuation of securities?

54.2.1 Valuation of equity shares

The concept of equity valuation follows the principle as already mentioned above. But, the
determination of valuation in this is bit more difficult because of the need to predict the dividend
and the price of the share (as expected) after a certain time period.

The basic ways to value equity shares are given below.

The common idea is:

P0=D1/(1+ke)+D2/(1+ke)2+D3/(1+ke)3+…….+Dn/(1+ke)n+ Pn/(1+ke)n………………………(1)

where D1 is the expected dividend at the end of period 1

D2 is the expected dividend at the end of period 2

D3 is the expected dividend at the end of period 3

Dn is the expected dividend at the end of period n

Pn is the expected price of the equity share at the end of period n (assuming n is the holding
period)

ke is the cost of equity capital

n is the holding period

Using the above concept, we shall discuss the valuation concept under different situations one by
one.

54.2.1.1 Valuation of equity share in case of single holding period

The above equation (1) will be modified as follows:

P0=D1/(1+ke)+P1/(1+ke)

This is the modified formula as n=1 (being a single holding period)

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Example 1: Compute the valuation of the equity share of EF Ltd. for a single holding period if it
is expected that the company will declare dividend of Rs. 10 next year and the price will be Rs.
100. Assume that the cost of equity is 12%.

Solution:

In such a case, the valuation will be done as follows:

P0=D1/(1+ke)+P1/(1+ke)

or, P0 = 10/1.12 + 100 / 1.12 = Rs. 98.21

54.2.1.2 Valuation of equity share in case of multiple holding periods (say 3 years)

Example: Compute the valuation of the equity share of CD Ltd. in case the share will be held for
three years if it is expected that the company will declare dividends of Rs. 10, Rs. 15 and Rs. 18
in the next three years. Also, the expected sales price at the end of the third year is Rs. 225.
Assume that the cost of equity is 14%.

Solution:

In such a case, equation (1) will be modified as follows:

P0=D1/(1+ke)+D2/(1+ke)2+D3/(1+ke)3+ P3/(1+ke)3 [as n = 3]

Thus, P0 = 10/1.14 + 15/(1.14)2 + 18/(1.14)3+225/(1.14)3

or, P0 = Rs. (8.77+11.54+12.14+151.86)

= Rs. 184.33

Continuing with the above example, should you purchase the equity share of CD Ltd. if the
trading price is Rs. 165.

The answer is yes since the market rate is less than the intrinsic value (should be price). Thus, by
buying at this price, the investor will purchase at a lower rate.

54.2.1.3 Valuation of equity share in case of infinite holding period

In this case, we assume that the share will be held for an infinite period, thereby denoting that it
is not going to be sold. Hence, the cash flows that are expected to be received by holding the
shares are only the dividends in different years i.e. D1, D2, D3,………, Dα

In this case, equation (1) will be modified as follows:

P0=D1/(1+ke)+D2/(1+ke)2+D3/(1+ke)3+…….+…………..till α

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54.2.1.4 Valuation of equity share in case of constant growth rate of dividends (under
limited holding period)

By constant growth rate of dividends, we mean that if the growth factor is g (in %), then the next
year dividend will be equal to present year dividend plus g% on present dividends. For example,
if present years’ dividend is D0, D1 = D0 + g%*D0 = D0 (1+g)

Similarly, D2 = D1 (1+g) = D0 (1+g)*(1+g) = D0 (1+g)2

D3 = D2 (1+g) = D0 (1+g)2*(1+g) = D0 (1+g)3

D4 = D3 (1+g) = D0 (1+g)3*(1+g) = D0 (1+g)4

Also, expect the price at the end of four holding periods to be P4

Thus, the valuation will be done as follows:

P0 = sum total of present value of cash flows by holding the security

= D1/(1+ke)+D2/ (1+ke)2+D3/(1+ke)3+D4/(1+ke)4+P4/(1+ke)4, assuming the cost of equity to be ke

54.2.1.5 Valuation of equity share in case of constant growth rate of dividends for infinite
holding period

In this case, we assume that the share will be held for an infinite period, thereby denoting that it
is not going to be sold. Hence, the cash flows that are expected to be received by holding the
shares are only the dividends in different years i.e. D1, D2, D3,………, Dα

In this case, equation (1) will be modified as follows:

P0=D1/(1+ke)+D2/(1+ke)2+D3/(1+ke)3+…….+…………..till α

The difference between this case and case (3) is that next years’ dividend is related to present
years’ dividend by a factor g.

Thus, D1 = D0 (1+g)

Similarly, D2 = D1 (1+g) = D0 (1+g)2

D3 = D2 (1+g) = D0 (1+g)3

D4 = D3 (1+g) = D0 (1+g)4 and so on.

Thus, the valuation (P0) will be done as follows:

P0=D1/(1+ke)+D2/(1+ke)2+D3/(1+ke)3+D4/(1+ke)4…….+…………..till α

or, P0=D0(1+g)/(1+ke)+D0(1+g)2/(1+ke)2+D0(1+g)3/(1+ke)3+D0(1+g)4/(1+ke)4…….+……till α

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contd. (see scanned image below)

54.2.1.6 Valuation of equity share in case of constant dividends for infinite holding period

In this case, we assume that the share will be held for an infinite period, thereby denoting that it
is not going to be sold. Hence, the cash flows that are expected to be received by holding the
shares are only the dividends in different years i.e. D1, D2, D3,………, Dα

In this case, since the dividends are constant, the values of D1, D2, D3,………, Dα remain the
same, say D.

In this case, therefore, equation (1) will be modified as follows:

P0=D/(1+ke)+D/(1+ke)2+D/(1+ke)3+…….+…………..till α

= D / ke

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54.2.1.7 Valuation of equity share in case of two-stage growth rate model

There may be cases where the dividend growth rate does not remain the same throughout.
Instead, there can be a case where the dividend grows at a particular rate for a particular time
after which it grows at a different rate throughout.

Let us consider the following case:

The initial phase extends till period N during which the dividend growth rate is g1%. After this
phase, the growth rate changes to g2% which extends till infinity.

The valuation is equity is done as follows:

For the period from 1 to N, the phase will named as first phase for which valuation is V1.

V1 = D1 / (1+ke) + D2 / (1+ke)2 + ………+ DN / (1+ke)N

For the next period from N+1 till infinity, the valuation will be as follows:

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Example

Calculate the value of equity share in the following case:

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The present dividend is Rs. 6. The dividends are expected to grow at the rate of 12% till the third
period after which it will continue to grow at the rate of 5% till infinity. Assume that the cost of
equity is 15%.

Solution

It is evident from the problem that it is a case of two-period growth rate. The valuation is done in
two phases - 1 and 2 for which the valuation will denoted as V1 and V2.

The total value will be equal to V1 + V2

V1 = D1/(1+ke) + D2 / (1+ke)2 + D3 / (1+ke)3

Here, D1 = D0 (1+g1) = Rs. 6*1.12 = Rs. 6.72

D2 = Rs. 6.72 * 1.12 = Rs. 7.52

D3 = Rs. 7.52 * 1.12 = Rs. 8.42

V1 = Sum total of present value of dividends from D1 to D3.

D4 = Rs. 8.42 * 1.05 = Rs. 8.84

V2 = Rs. 8.84/(0.15-0.05) * 1/(1.15)3

The intrinsic value of the equity share = V1 + V2

Check your progress

1. Derive the formula for equity valuation in the case of constant growth rate of
dividends for an infinite time period.

2. Calculate the intrinsic value of equity share if the present dividend is Rs. 12
and dividends are expected to grow at the rate of 10% for the next four
years. The expected sales price is Rs. 127 at the end of the four-year holding
period.

54.3 Valuation of Bonds or Debentures

Corporate houses issue debentures to raise long-term finance which therefore also forms a
component of the capital structure. They are also traded in the secondary market. Hence, the
importance and relevance of valuation also applies to debentures as decisions to purchase or sell
depends on the comparison between trading price and intrinsic value. Bonds are similar to

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debentures but these are securities which are issued by government enterprises. The similarities
between debentures and bonds are as follows:
• They have a fixed interest rate (called coupon rate in the case of bonds)
• They have a fixed maturity period (may be 5 years, 10 years, 15 years etc.)
• They have a redemption price which is mentioned on the face of the security.
In the case of bond, an investor receives interest from the bond and on maturity receives the
redemption price (or maturity price).
Thus, the valuation of bond, the cash flows to the investor come from two sources:
(i) Bond interest (denoted by I), and
(ii) Bond maturity price (denoted by M)
The difference between the valuation of equity shares and bonds is that in the former the cash
flows from dividends and sales price are to be estimated. But, in the latter case, the cash flows
are in the form of fixed bond interest (as it depends on the face value and coupon rate which are
pre-determined) and maturity price (which is also known before hand).
The formula for valuing bonds (B0) is as follows:
B0 = I1/(1+kb)+I2/(1+kb)2+……………….+In/(1+kb)n+Mn/(1+kb)n, ……………….(2)
where, B0 is the intrinsic value of the bond
I1 is the bond interest in first holding period
I2 is the bond interest in second holding period and so on
Mn is the maturity price on the bond at the end of maturity (after n-th period)
kb is the cost of capital of the bond (i.e. return expected by the bold holders)
Since, the bond interest remains the same, I1 = I2= I3= ……………….= In= I
Thus, equation (2) is modified as follows:
B0 = I/(1+kb)+I/(1+kb)2+ I/(1+kb)3+……………….+I/(1+kb)n+Mn/(1+kb)n

In case, the bond interest is paid half-yearly, the above equation will be modified as follows:

54.3.1 Valuation of zero-coupon bond (ZCB)

These are special types of bonds of very long tenure (say 25 years) on which the coupon rate is
zero. In other words, the investors do not earn any interest by holding the bond. The only cash
flow that arises from the bond is the receipt on maturity. Investors in spite of not getting any

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interest buy such bonds as they generally trade at a huge discount. These are therefore also
known as deep discount bonds. Thus, this low price acts as an incentive to purchase the bond.
The valuation of such bonds (denoted by B0) is derived using the following formula:
B0 = Mn / (1+kb)n, where-
B0 is the intrinsic value of the bond
Mn is the maturity value of the bond
kb is the cost of capital of the bond
n is the number of years to maturity
Example: Determine the intrinsic value of the zero coupon bond issued by CD Ltd., a
government enterprise:
Face value: Rs. 1000
Years to maturity: 5
Maturity value: At par
Cost of capital of the bond: 10% .
Also, decide whether you should purchase the bond if the trading price is Rs. 680
Solution:
The valuation will be done using the following formula:
B0 = Mn / (1+kb)n
Thus, B0 = Rs. 1000/(1.10)5 = Rs. 620.92
As the selling price is Rs. 680 and the intrinsic value is Rs. 620.92, the bond should not be
purchased.
In the case of zero-coupon bond, it is possible to determine the annual rate of return from the
bond which is known as the spot interest rate.
Mathematically, spot interest rate is that rate of return (discount rate) at which the market rate of
the bond equals the present value of the maturity price. If the present price is B and the maturity
price is M after n years, then spot interest rate (k) is computed as follows:
B = M/(1+k)n
If the present price is Rs. 750 and the maturity price is Rs. 1000 two years from now, then the
spot interest rate is computed as:
750 = 1000 / (1+k)2
or, (1+k)2 = 1.33
or, (1+k) = 1.1532
or, k = 0.1532 = 15.32%
Thus, the annual return on this bond will be 15.32%.
54.3.2 Concept of yield-to-maturity
This is another important concept that is used to measure return from bonds. It is that
compounded rate of return which an investor would earn by buying at the present market rate
and holding it till maturity. Hence, the term used is yield (to maturity). It is assumed that the
interest earned would be re-invested at this rate till maturity.

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Mathematically, yield to maturity (YTM) is that rate of discount at which the present market
price becomes equal to the sum total of present values of interest earned and the maturity value.
Thus, the cash outflow becomes equal to the sum of discounted cash inflows.
The relationship between cash outflow, cash inflows and the yield to maturity (YTM) is
expressed through this mathematical expression:

54.3.2 1 Computation of YTM

The computation of YTM is a tedious task. It can be calculated in two ways:
(i) Trial and error method
(ii) Short-cut method
Trial and error method
Under this method, we start with an estimated value of YTM and calculate the right hand side
(RHS) of the equation. If the right hand side equals the left hand side (LHS) value, that assumed
value is the value of YTM. If RHS > LHS, take another value which is more than the initial
assumed value and recalculate RHS.
If RHS < LHS, take another value which is less than the initial assumed value and then re-
calculated RHS.
After making the recalculation, the YTM can be calculated. The concept will be clear by solving
for YTM in the given problem.
Question: Calculate the value of YTM in the given case:
Face value of the bond is Rs. 1000
Market price of the bond is Rs. 900
Coupon rate is 15%
Maturity of the bond will take place after five years at par

Solution:
Trial and error method
The value of YTM can be determined using the trial and error method as follows:
Step 1: Assume an initial value of k, say 20%
The RHS value which is the sum total of all cash flows becomes Rs. 850.49
Step 2: Compare with the LHS value
Step 3: As RHS value is less than LHS value, take another value which is less than 20%, say
18%.
Step 4: Recalculate at k = 18%. We find that RHS = Rs. 906.18
Step 5: Now we apply interpolation to arrive at the value of YTM

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YTM = 18 + (906.18-900)*(20-18) /(906.18-850.49)
= 18+0.22 = 18.22%
OR
YTM = 20 – (900-850.49)*(20-18)/(906.18-850.49)
= 20 – 1.78 = 18.22%
Short-cut method
The other way of solving for YTM is by using the short-cut method.
YTM can be determined using the following formula:

where,
I = annual interest
M = maturity value at the end of the holding period
C = present market price of the bond
n = number of years to maturity
In the above problem, YTM can be computed as follows:
k YTM = 150 + (1000-900)/5 divided by (1000+900)/2
= 0.1789 = 17.89%
It can be seen from the two computations that the value differs. But, it will be seen that the two
values are quite close to one another.
Another concept which is closely related to bonds is that of yield to call. As the term denotes, the
concept applies to callable bonds (bonds which can be called back by the issuer before the
maturity of the bond). In cases of call, an option is given to the purchaser of the bond to
surrender the bond at the specified price (called callable price) at a specified period. Now, in
such a scenario, it is wise for the investor to decide whether to surrender or not to surrender the
bond. If the yield to call exceeds the yield to maturity, it is better to surrender the call and else
otherwise.

Check your progress

Q1. Discuss the concept of YTM.

Q2. What is spot interest rate?

Q3. Compute the intrinsic value of a zero-coupon bond having face value
of Rs. 1000 which is going to mature after 4 years. Assume that the cost of
bond is 11%.

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54.4 Valuation of Preference Shares
Preference shares are such securities that offer a fixed rate of dividend but without a maturity
date in many cases. In Indian market, it can be seen that are securities which have a year for
maturity and also which are perpetual in nature.
In case of perpetual preference shares, the valuation is done as follows:
Vpref = Dpref / i,
where D pref is the amount of preference dividend per share and i is the discount rate on the
preference shares
Example: An Indian company issued irredeemable preference shares @ Rs. 70. The company
pays an annual dividend of Rs. 5. The discount rate on the preference shares is 9%. Calculate the
intrinsic value of the security.
Solution:
As per the valuation concept, in the case of irredeemable preference shares, the valuation is done
using the formula:
V = Dpref / I = Rs. 5 / 0.09 = Rs. 55.55

Summary
The module covers the topic of valuation of securities. It introduces the concept of valuation and
points out its relevance for investors. The readers get acquainted with the topic relating to
valuation of equity shares (under different models), bonds and special bonds like zero-coupon
bonds and preference shares.

Glossary
Intrinsic value: It is the ‘should be price’ of a security.
Zero coupon bond: It is the bond on which the coupon rate is zero.
Yield-to-maturity: It is the yield that will be enjoyed by the holder of the security if it is held till
maturity.

Self-assessment Questions
Q1. Explain the term ‘intrinsic value’ and how it is calculated?
Q2. What is yield to maturity and yield to call in the case of a bond?
Q3. How do we value bonds?
Q4. Derive the formula for equity valuation in the case of two-growth rate model.

References
a. Francis, J. C.: Management of Investments, McGraw Hill, N.Y.
b. Fischer, D. E. and Jordan, R. J.: Security Analysis and Portfolio Management, Prentice
Hall, N. Delhi.

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c. Fuller, R. J. and Farrell Jr., J. L.: Modern Investments and Security Analysis, McGraw-
Hill, Singapore.
d. Raghunathan, V., Barua, S. K. and Verma, J.: Portfolio Management, TMH, N. Delhi.
e. Fabozzi, Frank J.: Investment Management, Prentice Hall, International Edition.
f. Kevin, S. : Portfolio Management, PHI, N. Delhi.
g. Pandian, P.: Security Analysis and Portfolio Management, Vikas Publishing House Pvt.
Ltd., N. Delhi.
h. Ranganatham, M. and Madhumati, M.: Security Analysis and Portfolio Management,
Pearson.

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