Securities and Business

Valuation

July 19, 2023 1

 Securities: An Overview
 A security is a financial asset representing a
unit of a right to:
 a financial obligation (debt security)
 an ownership of a going concern (equity security)
 A financial transaction
 The terms financial assets, financial
instruments and securities are often used
interchangeably
 Ownership to most securities is transferable
 Securities are traded in stock exchanges

July 19, 2023 2

 Securities: An Overview
 Securities are often classified into the following
broad groups:
 Debt securities – bonds (debentures)
 Debt securities differ in aspects such as the
issuer, length to maturity, yield type, issue type,
collateral, convertibility
 Equity securities – shares (stocks) differing in:
 Preference in dividend and liquidation (Common;
Preferred)
 Redemption (redeemable; non-redeemable)
 Voting rights
July 19, 2023 3
 Securities: An Overview
Securities classification (cont):
 Derivatives: derive value from price

movements of other securities or commodities

 Options (call, put); Futures; Forward contracts;
Swaps; Commodity based derivatives
 Stock and Bond Market Indexes
 “Cocktail” securities that track average (market)
returns of stocks and bonds
 Mutual fund securities
 Issued by firms that invest in financial assets

July 19, 2023 4

 Valuation of Securities: Book versus
Market Value
 In the books of accounts, securities are usually
recorded at original, historical value
 This is the book value
 For example, the book value of a share is the
owner’s net worth divided by the number of
shares outstanding
 Owner’s net worth is the difference between the
book value of assets and book value of liabilities
 We are assuming only one class of shares –
common shares
July 19, 2023 5
 Valuation of Securities: Book versus
Market Value
 The market value applies for securities that are
traded in securities markets
 The market value is determined in the market
based on the prospects of future cash flows,
their timing, and the riskiness of the cash flows
 The market value is the market price
 The market value of common equity (MARKET
CAPITALIZATION) is the product of the number of
shares outstanding times the current market value
per share
 It is the value that the market assign to the net worth

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 Valuation of Securities: Book versus
Market Value
 Usually, the book value and market value/price
are different
 They are determined on different basis
 Market values are usually larger than book value
 The focus on this part is on valuation of bonds
and stocks based on some theories
 Getting a value that one can compare with the book
and/or market value

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 Valuation of Securities
 Valuation of a security is important:
 In establishing whether a security is
appropriately priced
 The theoretical value of a market traded security
is the security’s market price
 However, sometimes a security may be trading
at a price that does not reflect its true worth
(fair value)
 In valuing non-traded securities

July 19, 2023 8

 Valuation of Securities
 Two concepts are crucial in valuation of
securities:
 Expectations
 Discounting
 The value of a security (i.e. the security’s
estimated market price) equals the sum of the
present values of expected future cash flows
using the opportunity cost of capital as a
discount rate

July 19, 2023 9

 Valuation of Securities
 Expected future cash flows
 Bond
 Periodic interest income
 The terminal value
 The repayment when the bond matures OR
 The price when the bondholder decides to sell the bond
 Stock
 Periodic dividend (when and if declared and paid)
 Proceeds when the stock is sold

July 19, 2023 10

 Cont….
 The discounting rate depends on
 The opportunity cost of capital – the risk-free rate
 The riskiness of the bond – this adds a risk
premium

July 19, 2023 11

 Valuation of Bonds - Coupon Bond
Coupon paying bond with a finite life.
For a bond that has a face value F, a coupon
rate c, n periods to mature, and a discounting
rate i, its estimated price is given as

C1 C2 Cn F
PB ,0  1
 2
 ...  n
 n
(1  i ) (1  i ) (1  i ) (1  i )
 Where Ci is the periodic interest
 With a fixed coupon rate c, the periodic interest C
is constant (i.e. C = c x F)

July 19, 2023 12

 Zero coupon Bond
 Are especially easy to price, since the coupon
rate is zero, it does not pay interest.
 Provides compensation to investors in the form
of price appreciation
 The value of a zero coupon bond is given as;
F
PB , 0 
(1  i ) n

July 19, 2023 13

 Perpetual Bond (Console)
 A perpetual bond is a bond with an infinite life
 Recall that the estimated price of a coupon bond with
coupon of Shs. C, face value of Shs. F, and maturity of
n periods is;

1  (1  i )  n
P0  C ( )  F (1  i )  n

i
The expression for the estimated price is reduced for
very large n, to give value of perpetual bond as,
C
P0 
i
July 19, 2023 14
 Example 1
Fast and Loose Company has outstanding an 8%, four year, $
1,000 par value bond on which interest is paid annually.
a) If the market required rate of return is 15%, what is the market
value of the bond.
b) What would be its market value if the market required return
dropped to 12%? To 8%?
c) If the coupon rate were 15% instead of 8%, what would be the
market value under part (a)? If the required rate of return
dropped to 8%, what would happen to the market price of the
bond?
d) Suppose that interest is paid semiannually, repeat part (a).

July 19, 2023 15

 Valuation of Stocks
 Conceptually, the approach used to value stocks is
similar to that used for bonds
 For a stock, we discount the expected dividends
and the expected price at the end of the holding
period with the required return on equity (ks)

e
D1 D2 Dn Pn
PS , 0  1
 2
 ...  n
 n
(1  k s ) (1  k s ) (1  k s ) (1  k s )

July 19, 2023 16

 Cont……..
 The approach used to value a stock that is going to
pay a dividend that is equal to the immediate
dividend, Do indefinitely, (Zero growth) is the same
as that used to value a perpetual bond
D0
PS 
ks
 The assumption here is that all profit is paid as
dividend (Do =EPS) and the investor is going to
hold the stock indefinitely

July 19, 2023 17

 Cont……..
 The assumption of a constant dividend and a price
that is not growing is a bit unrealistic
 A simplifying model of equity valuation assumes a
dividend and stock price that grow at a constant
rate, g
 For one period the stock’s price is estimated as

D0 (1  g ) PS , 0 (1  g )
PS , 0  
(1  k s ) (1  k s )

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 Cont…..
 This expression can be shown to equal:

D0 (1  g ) D1
PS ,0  PS , 0 
ks  g ks  g
 These expressions make sense when ks >g

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 Cont…..
 The expression is also valid for generalization with
a very long holding period
 Recall that for a very large N and k >g the
s
present value of the expected end price
approaches zero.
 This leaves

D0 (1  g )1 D0 (1  g ) 2 D0 (1  g ) N
PS , 0  1
 2
 ... 
(1  k s ) (1  k s ) (1  k s ) N

July 19, 2023 20

 Cont…..
 It can also be shown that this expression equals:
D0 (1  g ) D1
PS , 0  PS , 0 
ks  g ks  g
 When ks >g

July 19, 2023 21

 Cont…..
 In case of differential growth (growth phases),
dividends grow at two or more different rates in the
foreseeable future and then grow at constant rate
thereafter.
 Estimate future dividends in the foreseeable future,
estimate the future stock price when stock is constant
growth, then
 Compute the total present value of the estimated future
dividends and future stock price at the appropriate
discount rate.

July 19, 2023 22

 Examples
1. Suppose an investor is considering the purchase of a share of
the ABC mining company. The stock will pay a $ 3 dividend a
year from today. This dividend is expected to grow at 10%
per year for the foreseeable future. The investor thinks that
the required return on this stock is 15%, given her
assessment of ABC mining risks. What is the value of a share
of ABC Mining company stock?
2. ABC Corporation had paid a dividend of $ 10 per share in the
last year. Now the time for announcement of next dividend
has come. The market expectations are that the new
dividend shall be reflecting the growth of the industry and
would be $ 12. If the expected return by investors is 25%,
what price of the share do you expect?

July 19, 2023 23

 Cont……
3. A common stock just paid a dividend of $2. The dividend is
expected to grow at 8% for 3 years, then it will grow at 4% in
perpetuity. If stocks of similar risk earn 12% effective annual
return, what is the stock worth?
D0 = 2
D1 = 2(1.08) = 2.16
D2 = 2.16(1.08) = 2.33
D3 = 2.33(1.08) = 2.52
D4 = 2.52(1.04)= 2.62
At D4, this is a constant growth therefore, value of this at time 3 is given as
V = 2.62/(0.12-0.04) = 32.75
Discounting these cash flows at r = 12% results to the following;
2.16/1.12 + 2.33/(1.12)² +2.52/(1.12)³ + 32.75/(1.12)³
Price of stock is = 28.89

July 19, 2023 24

 Valuation of Firms cont….
 Increased significance has been due to
 Increased globalization and liberalization
 Understand what drives and creates value
 Valuation as a prerequisite for decision making e.g takeovers,
mergers, investments.
 Factors affecting valuation - External
 Availability and credibility of information
 State of demand and supply
 Market efficiency
 Legal environment
 Control of management

July 19, 2023 25

 Cont……
 Methods of valuation
i. Adjusted balance sheet approach
ii. Market value approach
iii. Discounted cash flow approach
iv. Free cash flow approach
v. Comparable approach /Relative Approach
 While valuing assets or business, the following should be considered
i)The assets being valued (ii) the objective of the valuation (iii) for whom valuation is
being done
(iv) the time frame under consideration.

July 19, 2023 26

 1. Adjusted balance sheet approach
 Based on financial statements after making suitable
adjustments to the value of assets and liabilities.
 The excess value of assets over liabilities belongs to the
shareholders.
 The assets and liabilities as per the books of account can be
replaced with either market value, Replacement value or liquidation
value. The selection depends on purpose of valuation.
 Value of intangibles not stated on financial statements e.g.
human resources, intellectual capital, patents, brands

July 19, 2023 27

 2 . Market value approach
• Valuation of the firm based on market value of
equity and debts issued by the firm. Add the market
value of all outstanding securities of the firm.
Example:
Suppose XYZ Co. had 1.5 million outstanding shares at
the closing price of Tzs 20 on that day, thus equity
has a market value of;
1.5 shares x 20 = Tzs 30 million. The firm also had
outstanding debt with market value of Tzs 21 million.
Therefore the total firm value of Tzs 51 million.

July 19, 2023 28

3. Discounted Cash Flow approach
• This is similar to valuing a capital project using the present
value method but involves forecasting cash flows over an
indefinite period of time for an entity that is expected to grow.
- DCF Valuation with growth
- Stable growth
• Use of cash flows and cost of capital as basic inputs for
valuation
Steps involved in this approach;
i) Forecast the cash flow during the explicit forecast period

July 19, 2023 29

 ii) Establish the cost of capital
iii) Determine the continuing value at the end of the explicit
forecast period
iii) Calculate the firm value and interpret results.

• The Gordon dividend discount Model (DDM) can be used

to compute the value of the firm under a constant rate of
growth.

July 19, 2023 30

Value of firm and value of equity
 Value of firm
Value of equity is given as VE =

and Value of firm =

Value of firm = Value of equity + Value of Debt

 Levered and unlevered firm

July 19, 2023 31

Example 1 using DDM
ABC Co. widened its product range by adding three new
brands which would boost its growth rate for the
next 7 years to a level of 30%, thereafter growth
rate will taper off and settle at 8%. Current earnings
per share of the firm is Tzs 5.25 and company
follows a policy of 40% dividend payout. The firm is
likely to maintain its payout for the next seven years
after which is likely to go up to 70%, Current beta of
ABC is 1.35 which will likely drop to 1.10 from eighth
year onwards. The current yield on T-bills is 5.50%
while average market risk premium is 7.85%.

July 19, 2023 32

 Example cont…….Determine the expected current value
of shares of ABC.

Value of equity share = 23.70 + 142.66 = 166.36

July 19, 2023 33
Example 2:
Deeptan Ventures Ltd has entered the phase of maturity
in its life cycle and its cash flows (before interest and
taxes) are expected to remain constant at the current
level of $ 550.25. Presently it is an all equity financed
firm. The cost of equity for Divyajyoti Enterprises which
resembles Deeptam in terms of its risk return
characteristics, is 15.75%. You are expected to find out
the value of Deeptam Ventures. The tax rate applicable
to Deeptam is 38.5%.

July 19, 2023 34

Example cont…….
b) What will be the impact on firm’s cost of equity,
WACC and its valuation if the firm decides to alter its
capital structure to have a 25% debt ratio. Suppose
that due to altering the capital structure, the cost of
equity will be 16.88%. The cost of debt for firms with
the risk profile similar to Deeptam Ventures is 10.25%.

July 19, 2023 35

 Example cont…….

July 19, 2023 36

 4. Free cash flow approach
• Valuation method of discounting the free cash
flows (FCF) of the firm with an appropriate
discount rate.
• Values the cash flows available to investors after
providing for capital expenditure and increase in
working capital deemed essential for growth.
• Under FCF approach, the firm may be valued
separately for debt holders and equity holders. If
valued separately the cash flows of each supplier
of capital are discounted at the respective cost of
capital.

July 19, 2023 37

 • FCF to the firm – the C/flows available to all suppliers
of capital to the firm after meeting business needs.
To determine FCF to shareholders and the firm:
 FCFE = NI + Depreciation – Capital expenditure - increase in
working capital + Net borrowing
 FCFF = Operational EBIT(1-Tax rate) + Depreciation - capital
expenditure - increase in working capital.

July 19, 2023 38

 Example 3
Mico Steels is contemplating the acquisition of Triven
Ores. Iron ore being an important raw material input in
steel production, such an acquisition is likely to assure
the supply of iron ore by taking care of 65% of iron ore
needs of Mico Steels. Triven Ltd is likely to grow at a
rapid pace during the first eight years after acquisition.
Thereafter the growth rate will taper off and settle
down at negligible level. Triven Ltd is an unlevered firm
with 25.75 outstanding equity shares and beta of 1.65.
The projected earnings of Triven Ores for the next eight
years are given below

July 19, 2023 39

 Acquisition of Triven Ores will enhance the debt
raising capacity of Mico which will be able to raise
debt up to 25% of its value. The cost of debt for
Triven Ltd will be 9.75%, the risk free rate is 5.75%
and the historical risk premium is 10.25%. The
corporate tax rate is 38.5% and the levered beta for
Triven will be 2.2.
a) Determine the FCF and WACC
b) What is the value of Triven Ores Ltd.

July 19, 2023 40

 Example cont…….

July 19, 2023 41

 Example cont……Free cash flows of Triven Ores are
determined as follows. Amount in millions

July 19, 2023 42

Example cont…….
Estimation of the cost WACC and value of Triven Ores

July 19, 2023 43

 5. Comparable Approach / Relative valuation
• This is based on the premise that similar asset must
trade at similar prices.
• The important issue is to find the similarities in the
asset being compared and the asset being valued.
 Direct comparable approach is used where almost
identical assets are available for comparison but
where not possible relative valuation is used.
 Relative valuation is where similar but not
identical asset is used to arrive at the valuation.

July 19, 2023 44

 Steps in relative valuation
1. Identify the comparable firms in the same line of
business. Firms must have value determined by the
market and all parameters must be available along which
valuation is contemplated
2. Identify the parameters of valuation – can be sales,
book values, EBITDA
3. Estimate the market value along the parameter to find
the multiple assigned by the market
4. Project the value of the parameter for the firm being
valued and use the value of the multiple to get the
valuation.

July 19, 2023 45

 Relative valuation cont…
Two managerial decisions that determine the efficacy of relative valuation
 The definition of a comparable - finding an exact match of
the firm being valued in the corporate world is difficult due to
differences in sizes, locations, earnings capabilities , financial
characteristics, capital structure.
 Industry analysis and average of sample to make comparison
among firms
 The choice of multiple – commonly used multiples include
earnings, book value, revenue and sector specific multiple in
respect of the earnings , revenue and book values available.
 Choice depends with the analyst who determines relevance
of multiple

July 19, 2023 46

  What are the advantages and limitations of Relative
valuation?
Example 4:
XYZ is manufacturing a wide range of chemicals and
intending to come out with an IPO to issue 10
million shares. It is projecting an earning of $ 3
per share with the revenue of 650 million. You
have been able to identify four firms in the same
line of approximately the same size. The
following information about the firm is available.

July 19, 2023 47

 Example cont…..
a) What price can the firm issue its shares? Assume
that the market gives twice as much importance
to earning per share than either to book value or
revenue. Ignore book value

July 19, 2023 48

 Example: determining the price to charge

July 19, 2023 49