Valuation of Securities

Valuation Approaches
• Intrinsic valuation
• The value of an asset is a function of its fundamentals – cash flows, growth and
risk. In general, discounted cash flow models are used to estimate intrinsic value.
• Relative valuation
• The value of an asset is estimated based upon what investors are paying for
similar assets. In general, this takes the form of value or price multiples and
comparing firms within the same business.
• Contingent claim valuation
• When the cash flows on an asset are contingent on an external event, the value
can be estimated using option pricing models.
Equity Valuation (Dividend Discount Model-
Finite Period Investment)
• The market value of a share of stock today equals the combined
present value of two future cash inflows, the expected end-of-period
dividend and the expected end-of-period stock price.

𝐷1 𝐷 2+ 𝑃 2
𝑃 0= 1
+ 2
( 1+𝑟 ) (1+𝑟 )
OR
𝐷1 𝐷2 + 𝑃 2
𝑃 0= 1
+
( 1+ 𝐾𝑒 ) (1+ 𝐾𝑒 )2
Equity Valuation
• Spandan is willing to invest in a company for three years. The firm will
pay a dividend of Rs. 20 in first year, Rs. 30 and Rs. 40 in next two
years. The stocks can be sold for Rs. 400 at the end of 3rd year.
Determine the price of equity share if the cost of equity is 9%.
Equity Valuation (Dividend Discount Model-
Constant Dividend Model)

D1 D2 D
Po   2
 ...  
(1  ke ) (1  ke ) (1  ke )
If , D1  D2  ...  D
D1
ke 
Po
Equity Valuation
• If ABC Ltd. issues equity capital, it will pay a dividend
of Rs. 8 per year and the cost of equity is 11%.
Determine the value of the equity share assuming the
dividends will remain constant forever.
Equity Valuation (Dividend Discount Model-
Dividend Growth Model)
Do (1  g )1 Do (1  g ) 2 Do (1  g ) n
P0  1
 2
 ...  n
(1  ke ) (1  ke ) (1  ke )
D1
Po 
ke  g

• Assumptions
• Market value of shares depends upon the expected dividends
• Do>0
• Dividend pay-out ratio is constant
Equity Valuation
• Suppose that dividend per share of a firm is expected to be
Rs.1 per share and is expected to grow at 6% per year
perpetually. Determine the price of the share if the cost of
equity capital is 10%.
Equity Valuation
• Suppose a company’s expected dividends are Rs. 1, Rs. 2, and
Rs. 3 for the next three years and are expected to grow at a
constant rate of 6% per year thereafter. What should the
current price be if the required rate of return is 15%?
Bond Valuation
• Features of Bonds/Debentures
• Long-term claims against company assets
• Face, or par, value is Rs. 1,000 (unless different amount is specified)
• Coupon rate is the annual coupon payment (C) divided by a bond’s face value
(FV)
• Coupon payment is a fixed amount paid to lenders for the life of the bond
• Carries fixed maturity period (if redeemable)
• The issue price may be at par, premium and discount
• The redeemable price may be at par, premium and discount
Types of Bonds
• Vanilla bonds, also called a debentures, are typically unsecured
• Coupon payments fixed for the life of the bond
• Repay principal and retire the bonds at maturity
• Annual or semiannual coupon payments
• Zero coupon bond
• No coupon payments
• Pays face value at maturity
• Sell at deep discount
• Convertible bonds
• May be exchanged for shares of the firm’s stock
• Sell for a higher price than a comparable non-convertible bond
• Bondholders benefit if the market value of the company’s stock gets high enough
Bond Valuation
• To calculate bond price, determine
• The required rate of return, r or kd
• Expected future cash flows: coupon payments and par value
• The price is the present value of the future cash flows

OR
Bond Valuation Example
Yield to Maturity (YTM)
• Yield to Maturity (YTM) is the rate that makes the present value of the bond’s
cash flows equal to the price of the bond
• i.e., YTM is the rate a bondholder earns if the bond is held to maturity and all coupon and
principal payments are made as promised
• YTM changes daily as interest rates change
• YTM Can be calculated using following formula.

• Where RV is redeemable value, IP is issued price, n is number of year, C is coupon.

Example
• PPL has issued a debenture with face value of Rs. 1000. The bond was
issued at a premium of 5% for 10 years. The redeemable price of the
bond is Rs. 1100 and coupon per year is 100. Compute the YTM.
 Semiannual Compounding
• Most bonds issued in Europe pay annual coupons, but bonds issued in
the U.S. usually pay semi-annual coupons
Example
• PPL issued a four-year bond with a coupon of 8 per cent. The bond
pays interest semi-annually. If the yield to maturity on this bond is 9
per cent, what is the price of the bond?
𝐶/𝑚 𝐶/𝑚 𝐶/𝑚 𝐶 / 𝑚+ 𝑅𝑉 8
𝑉 𝐵= + + +…+
1+𝑟 / 𝑚 ( 1+𝑟 / 𝑚 )2 ( 1+𝑟 / 𝑚 )3 ( 1+𝑟 / 𝑚 )8

40 40 40 40 +1000
¿ + + +…+
1.045 ( 1.045 )2 ( 1.045 )3 ( 1.045 )8

¿ 38.28+36.63+ 35.05+33.54+32.10 +30.72+29.39+732.31

Zero Coupon Bonds
• Zero Coupon bonds pay face value at maturity, but do not make
coupon payments
• The yield of a zero coupon bond is therefore the present value of the
par value
• Zero coupon bonds pay cash only at maturity; they sell for less than
similar bonds which make periodic interest payments
Example
• Amman is looking to purchase a zero-coupon bond with a face value
of Rs. 1,000 and 5 years to maturity. The interest rate on the bond is
10% compounded annually. What price will Amman pay for the bond
today?
𝑅𝑉 𝑛
𝑉 𝑍=
( 1+𝑟 )𝑛

1000
𝑉 𝑍=
( 1+0.10 )5

𝑉 𝑍 =620 . 921
Factors Affecting the Valuation of Bonds
• Interest rate risk
• Marketability
• Call provision
• Default risk
• Term-to-maturity etc.
 Relative Valuation
The “value” of any asset can be estimated by looking at how the market prices
“similar” or ‘comparable” assets.
• Philosophical basis: the intrinsic value of an asset is impossible (or close to
impossible) to estimate. The price of an asset is whatever the market is willing
to pay for it (based upon its characteristics)
 Information needed: to do a relative valuation, you need

•  an identical asset, or a group of comparable or similar assets

•  a standardized measure of value (in equity, this is obtained by dividing the price by a

common variable, such as earnings or book value)

•  and if the assets are not perfectly comparable, variables to control for the differences

• Market inefficiency: pricing errors made across similar or comparable assets

are easier to spot, easier to exploit and are much more quickly corrected.
Advantages of Relative Valuation
• In sync with the market: relative valuation is much more likely to reflect
market perceptions and moods than discounted cash flow valuation.
• With relative valuation, there will always be a significant proportion of
securities that are under valued and over valued. Since portfolio managers are
judged based upon how they perform on a relative basis (to the market and
other money managers), relative valuation is more tailored to their needs
• Relative valuation generally requires less explicit information than discounted
cash flow valuation.
• In relative valuation, you are playing the “incremental” game, where you hope
to make money by getting the next increment (earnings report, news story
etc.) Right.
Disadvantages
• A portfolio that is composed of stocks which are under valued on a relative basis
may still be overvalued, even if the analysts’ judgments are right. It is just less
overvalued than other securities in the market.
• Relative valuation is built on the assumption that markets are correct in the
aggregate, but they make mistakes on individual securities. To the degree that
markets can be over or under valued in the aggregate, relative valuation will fail.
•  Relative valuation may require less information in the way in which most
analysts and portfolio managers use it. However, this is because implicit
assumptions are made about other variables (that would have been required in a
discounted cash flow valuation). To the extent that these implicit assumptions
are wrong the relative valuation will also be wrong.