Valuation of Securities

By Divya Tara Nitesh Sonali Mohit Sharma

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What is Value?

In general, the value of an asset is the price that a willing and able buyer pays to a willing and able seller Note that if either the buyer or seller is not both willing and able, then an offer does not establish the value of the asset

Several Kinds of Value

There are several types of value, of which we are concerned with three:
Book Value - The assets historical cost less its accumulated depreciation Market Value - The price of an asset as determined in a competitive marketplace Intrinsic Value - The present value of the expected future cash flows discounted at the decision makers required rate of return

Determinants of Intrinsic Value

There are two primary determinants of the intrinsic value of an asset to an individual:
The size and timing of the expected future cash flows The individuals required rate of return (this is determined by a number of other factors such as risk/return preferences, returns on competing investments, expected inflation, etc.)

Note that the intrinsic value of an asset can be, and often is, different for each individual (thats what makes markets work)

Types of Securities

Debentures
Equity Preference Shares

Bonds

A debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing. Some bonds do not pay interest, but all bonds require a repayment of principal. When an investor buys a bond, he/she becomes a creditor of the issuer.

Types of Bonds

Government Bonds These are basically long term bonds issued by RBI on behalf of GOI. Corporate Bonds Companies borrow money by issuing bonds called corporate bonds or corporate debentures.

Types of Corporate Bonds

Straight Bonds It is also called as plain vanilla bond. It pays fixed periodic coupon over its life and returns the principle on the maturity date. Zero Coupon bonds A zero coupon bond does not carry any regular interest payment .It is issued at a steep discount over its face value and redeemed at face value on maturity. Floating Rate bonds These do not pay fixed interest but pay a benchmark rate such as the treasury bill interest rate.

Types of Corporate Bonds (Conti.)

Bonds with embedded options

These options give certain rights to the investors or issuers: 1. Convertible Bonds Gives the bond holder the right to convert them into equity share on certain terms 2. Callable Bonds Gives the issuer the right to redeem the bonds issued by them on certain terms 3. Puttable Bonds Gives the investor the right to prematurely sell the bonds back to the issuer on certain terms.

Bond Yields

Bonds are generally traded on the basis of their prices. However they are not usually compared on the basis of their prices because of significant variations in their cash flow patterns and other features. Instead they are compared in yields.

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Commonly employed yield measures

Current Yield 1. It related the annual coupon interest to the market price. Current yield= Annual Interest/Price Eg: The current yield of a 10 year and 12% coupon rate bond with par value of Rs.1000 and selling of Rs.950 is = .12*1000/950 = 12.63 2. It reflects only coupon interest rates. It does not consider capital gain or loss that an investor will realise if the bond is purchased at discount or premium. It ignores time value of money

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Commonly employed yield measures (Conti.)

Yield to Maturity This method is employed to anticipate the gross rate of returns offered by the bond over its life.

P= [C/(1+r)]+[C/(1+r) 2]-----+ [C/(1+r) n]+ [M/(1+r) n] C= Annual Interest in Rupees M=Maturity Value in Rupees n=No of years left to maturity P=Price of bond r=Coupon Rate
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Eg: A Rs.1000 par value bond carrying a coupon rate of 9% and maturing after 8 years.The bond is currently selling for Rs.800. What if the YTM on this bond?
800= [90/(1+r) 8]+ [1000/(1+r) 8] By hit and Trial =90 (PVAF 12%,8 yrs) + 1000 (PVF 12%,8 yrs)= Rs.851.0 =90 (PVAF 14%,8 yrs) + 1000 (PVF 14%,8 yrs) =Rs. 768.1 =90 (PVAF 13%,8 yrs) + 1000 (PVF 13%,8 yrs) =Rs. 808 Applying interpolation: 13%+(14%-13%)*(808-800/808-768.1)=13.2% OR YTM = C+(M-P)/n = 90+(1000-800)/8 = 13.1% 0.4M+0.6P 0.4*1000 + 0.6*800

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Yield to Call Some bonds carry a call feature that entitles the issuer to buy back the bonds prior to the stated maturity date. For such bonds both YTC and YTM are calculated: YTC=[C/(1+r) t]+ [M*/(1+r) n*]

Where n*= No of years until the call date M*=Call Price

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Risks in Bond

Inflation Risk The interest rates are declared in nominal terms. Thus it should be adjusted with the expected inflation. Default Risk It is the risk that the borrower may not pay the interest or principle on time. Call risk The issuer may buy back the bond when the interest rates are declining. This risk is attractive from the issuer point of view but not from the investor point of view. Liquidity Risk Barring for some of the popular govt securities most of the debt instruments are not traded actively. Thus there is poor liquidity in the debt market and the investors face difficulties in trading the same.
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Risks in Bond (Conti.)

Reinvestment Risk When the bond pays periodic interest there is a risk that the interest payments may have to be reinvested at a lower interest rate. This risk is greater for bonds with longer maturity and higher interest payment. Foreign Exchange Risk If a bond has payments that are dominated by foreign currency it rupee cash flow is uncertain as there is a risk of depreciation of rupee in comparison to foreign currency. Interest Rate Risk Interest rates tend to vary causing fluctuations in bond prices.

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Bond Terminology

There are several terms with which you must be familiar to solve bond valuation problems:
Coupon Rate - This is the stated rate of interest on the bond. It is fixed for the life of the bond. Also, this rate time the face value determines the annual interest payment amount. Face Value - This is the principal amount (nominally, the amount that was borrowed). This is the amount that will be repaid at maturity Maturity Date - This is the date after which the bond no longer exists. It is also the date on which the loan is repaid and the last interest payment is made.

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Calculating the Value of a Bond

There are two types of cash flows that are provided by a bond investments:
Periodic interest payments (usually every six months, but any frequency is possible) Repayment of the face value (also called the principal amount, which is usually $1,000) at maturity

The following timeline illustrates a typical bonds cash flows:

100
0 1

100
2

100
3

100
4

1,000 100 5

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Calculating the Value of a Bond (cont.)

Redeemable Bond Vd=I(ADFI)+F(DFF)
Vd= Value of Bond or Debenture

I=Interest Payable on bond/Coupon Rate ADFI=Annuity discount factor applicable to interest DFF= Appropriate discount factor applicable to face value F= Face Value

Irredeemable Bond

Vd=A/i A=Interest Amount i = Expected Rate of Interest

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Bond Valuation: An Example

Assume that you are interested in purchasing a bond with 5 years to maturity and a 10% coupon rate. If your required return is 12%, what is the highest price that you would be willing to pay?
100 0 1 100 2 100 3 100 4 1,000 100 5

= Present value for annuity for 100 @ 12% + present value of 1000 for 5 years @ 12%
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Some Notes About Bond Valuation

The value of a bond depends on several factors such as time to maturity, coupon rate, and required return We can note several facts about the relationship between bond prices and these variables:
Higher required returns lead to lower bond prices, and viceversa Higher coupon rates lead to higher bond prices, and vice versa Longer terms to maturity lead to lower bond prices, and vice-versa

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Common Stocks /Equity

A share of common stock represents an ownership position in the firm. Typically, the owners are entitled to vote on important matters regarding the firm, to vote on the membership of the board of directors, and (often) to receive dividends. In the event of liquidation of the firm, the common shareholders will receive a pro-rata share of the assets remaining after the creditors and preferred stockholders have been paid off. It can be Single period or multiple period
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Common Stock Valuation

Just like with bonds, the first step in valuing common stocks is to determine the cash flows For a stock, there are two:
Dividend payments The future selling price

Again, finding the present values of these cash flows and adding them together will give us the value

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Common Stock Valuation: An Example

Assume that you are considering the purchase of a stock which will pay dividends of $2 next year, and $2.16 the following year. After receiving the second dividend, you plan on selling the stock for $33.33. What is the intrinsic value of this stock if your required return is 15%?
? 2.00 33.33 2.16

VCS

1.15

2.00

2.16 33.33

1.15

28.57

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Calculating Value of Equity

Valuation of equity when there is a constant growth rate in dividend for a finite period

D1 VCS k CS g k CS g
D0 = Current Dividend D1 = Expected Dividend g = Growth Rate of Dividend Kcs = Expected Return on common stock Vcs = Value of Common Stock
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D 0 1 g

An Example

Recall our previous example in which the dividends were growing at 8% per year, and your required return was 15% The value of the stock must be:

VCS

1851.08 . .15.08

2.00 28.57 015.08 .

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Calculating Value of Equity

When there is constant growth of dividend for infinite period (Earning Capitalisation Approach)
V = Amount of Dividend / Ke

For Example: ABC Ltd is currently paying dividend @ Rs.60 .The current yield is 15%. Calculate the value of share. Ans: 60/.15 = 400
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Preferred Stock

Preferred stock represents an ownership claim on the firm that is superior to common stock in the event of liquidation. Typically, preferred stock pays a fixed dividend periodically and the preferred stockholders are usually not entitled to vote as are the common shareholders.

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Preferred Stock Valuation

Redeemable Preference Share Basically, the value of a redeemable preference share is the present value of all the future expected dividend payments and the maturity value, discounted at the required return on preference shares. Value of redeemable preference share=
Dividend1 + (1+r) 1 Dividend2 +.+ (Dividend n +maturity value) (1+r) 2 (1+r) n

value of an irredeemable preference share =

dividend required return on preference share
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Example:
Let us assume the face value of the preference share is Rs 500 and the stated dividend rate is 12%. The shares are redeemable after 5 years period. Calculate the value of preference shares if the required rate of return is 13%. Annual dividend = 500 x 12% =Rs 60 Redeemable Preference share value = 60 + 60 (60+500) ( 1+.13)1 ( 1+.13)2 ( 1+.13)5

Solving for the above equation, we get the value of the preference shares as Rs 482 (rounded).

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Thank you

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