VALUATION OF BONDS AND SHARES

Introduction
Valuation is the process that links risk and return to determine the worth o
f an asset. It can be applied to future benefits ( expected cash flows) bot
h form real assets and financial assets.
First Principles:
Value of financial securities = PV of expected future cash flows.
To value bonds and stocks we need to:
Estimate future cash flows: size (how much) and timing (when).
Discount future cash flows at an appropriate rate.
Basic Valuation Model:

An
A1
A2

........

(1 k )1 (1 k ) 2
(1 k ) n

Bonds/Debentures
Bond - debt issued by a corporation or a governmental body.

A bond represents a loan made by investors to the issuer.

In return for his/her money, the investor receives a legal claim on futur
e cash flows of the borrower.

Par value- is the value on the face of the bond.

Coupon rate is the specified interest rate.
Maturity Period-refers to the number of years after which the par value is pa
yable to the bondholder.
Default-an issuer who fails to pay is subject to legal action on behalf of the le
nders (bondholders).

Bond Valuation
A firm has issued a 10% coupon interest rate, 10 year bond with a tk. 1
000 par value that pays interest annually.
Requirement: (1) basic bond valuation, (2) yield to maturity, (3) semi-an
nual interest and bond values.
Basic Bond Valuation:

I
M

t
(1 k d ) n
t 1 (1 k d )

= I* (PVIFAkd,n)+ M (PVIFkd,n)
= 100*6.145 + 1000*0.386
= 614.5+386
= 1000
* Calculate value at coupon rate 12% and 8%.
When the required return is equal to the coupon rate, the bond value equals the
par value.

Bond Valuation
Points to be remembered: Bond value is affected by two factors (1) req
uired rate of return and (2) time to maturity.
Yield to Maturity (YTM): The YTM is the rate of return that investors ear
n if they buy a bond at a specific price and hold it until maturity.
Example: The bonds of the premier company Ltd. are currently selling f
or tk. 10,800. Assuming (1) coupon rate 10% annually, par value 10,0
00, and time to maturity- 10 years; calculate YTM.
YTM (Trial and Error Method):
Tk. 10,800= tk. 1000 (PVIFA kd,10) + tk. 10,000 (PVIFkd,10)
At 9%,
= 1000*6.418 + 10,000* .422 = 10,638
At 8%,
= 1000* 6.710 + 10,000* .463= 11,340
Thus, the YTM = 8.77 percent.

Bond Valuation
Semi-annual Interest and Bond Valuation: The value of a bond selling a
t a discount is lower when semi-annual interest is used compared to an
nual interest. For bonds selling at a premium, the value with semi-annu
al interest is greater than with annual interest.
Perpetual Bond: A perpetual bond is a bond with no maturity date. Perp
etual bonds are not redeemable but pay a steady stream of interest for
ever.
The value of a perpetual bond is,
p0 = Interest / required rate of return

Valuation of Preference shares

Preference shares, like debentures, are usually subject to fixed rate of r
eturn/dividend. In
case of no maturity,
n

v
t 1

Dp
(1 r )

Dp
r

Valuation of Ordinary Shares

The ordinary shareholders buy/hold shares in expectation of periodic ca
sh dividends and an increasing share value. They would buy a share wh
en it is undervalued and sell it when its market price is more than it true
price.
The value of a share is equal to the present value of its all future dividen
ds it is expected to provide over an infinite time horizon. Symbolically,

D1
D2
D

..........

(1 ke )1 (1 ke ) 2
(1 ke )

Valuation of Ordinary Shares

D1
Zero Growth Model: P=
ke
D0 (1 g )1 D0 (1 g ) 2
D0 (1 g )
Constant Growth Model: P

.........
1
2
(1 ke )
(1 ke )
(1 k e )
or P=

D1
ke g

Valuation of Ordinary Shares

Variable Growth Model: Variable growth model incorporates a change i
n the dividend growth rate. Assuming g1= initial growth rate and g2= the
subsequent growth rate occurs at the end of year N, the value of the s
hares can be determined as follows:
N

P=

t 1

D0 * (1 g1 ) t
DN 1
1

N
(1 k e ) t
Ke g2
(1 k e )

Other Approaches to Valuation of Shares

Book Value Approach: The book value per share is the net worth (equity ca
pital plus reserves and surplus) divided by the number of outstanding equi
ty shares.
Alternatively, it is the amount per share on the sale of the assets of the co
mpany at their exact book value minus all liabilities including preference s
hares.
Liquidation Value: Liquidation value per share can be determined as follow
s:
Value realized from liquidation Amount to be paid to all creditor
s
LVPS =
number of outstanding shares

Other Approaches to Valuation of Shares

Price/Earnings (P/E) Multiples / Ratio: Its a measurement of how expe
nsive a stock is.
Price of a share Earnings per share.