Valuation of securities

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)

Basic valuation model

The value of any asset, real or financial, is equal to the present value Of the cash flows expected from it. C1 (1+k)1 C2 + (1+k)2 Cn (1+k)n

V0=

+ ..+

= PVIF k,n

Where: V0=value of the asset at time zero Cn=cash flow expected at the end of year n. k=discounted rate applicable to the cash flows n=life of the asset.

Bonds

A bond is a tradeable instrument that represents a debt owed to the owner by the issuer. Most commonly, bonds pay interest periodically (usually semiannually) and then return the principal at maturity. Most corporate, and some government, bonds are callable. That means that at the companys option, it may force the bondholders to sell them back to the company. Ordinarily, there are restrictions on the timing of the call and the amount that must be paid.

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: 1,000

100
0 1

100
2

100
3

100
4

100
5

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.

Calculating the Value of a Bond

V=
t=1

I (1+kd)t

F +

(1+kd)n F(PVIF kd,n)

V= I(PVIFA kd,n) +

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 (ceteris paribus):

Higher required returns lead to lower bond prices, and vice-versa Higher coupon rates lead to higher bond prices, and vice versa Longer terms to maturity lead to lower bond prices, and vice-versa

Current Yield

Current yield

Annual interest

Price It reflects only the coupon interest rate. It does not consider the capital gain (or loss) that an investor will realise if the bond is purchased at a discount (or premium) and held till maturity. It ignores the time value of money

Price-yield Relationship
Price Premium Par Discount

Yield
10% 14% 18%

Price-yield Relationship

Coupon rate > required yield---------price >par (Premium bond) Coupon rate = required yield---------price = par Coupon rate < required yield---------price < par (Discount bond)

Relationship between bond price & time

Price of bond

Premium bond: rd=11%

1100 A Par value bond: rd=13%

1000
900

B Discount bond: rd=15%

Years to maturity

Yield to maturity (YTM)

It is the interest rate that makes the present value of cash flows receivable from owning the bond equal to the price of the bond.
C + (M-F) / n

YTM
0.4 M+0.6 P

Equity Valuation
Dividend Discount Model

Value of equity share =PV of div + PV of the sale price expected when the equity share is sold.

Assumptions:
Dividends are paid annually The first dividend is received one year after the equity share is bought.

(i) (ii)

Single-period valuation model

P0= D1
(1+r)

P1
(1+r)

When Price Grows at a Rate of g%

P0= D1
(1+r)
+

P0(1+g)
(1+r) r-g

simplifying this we get P0= D1

Expected rate of return

r =D1/P0+g
Multi period valuation model + -----+ D (1+r) Dt

P0 = D1

D2

(1+r)1 (1+r)2 Dt Pn = = t (1+r) n (1+r) t=1

t=1 (1+r) t

Equity Valuation: the P/E ratio approach

This is practised widely by investment analysts P0 = E1 X Price Earning Ratio
Where P0=estimated

price E1=estimated earnings per share P0/E1=(1-b)

r - ROE X b