SECURITY VALUATION

SOUMENDRA ROY
 CONCEPT OF VALUATION
• The term ‘valuation’ expresses the task of estimating
the value of an asset, a security or a business.
• The price an investor or a buyer is willing to pay to
purchase a specific asset or security would be related
to this value.
• Obviously, two different buyers may not have the same
valuation of asset as their perception regarding its
value may vary, one may perceive the asset to be of
higher value than the other.
• A seller would consider the negotiated selling price of
the asset to be greater than the value of the asset he is
selling.
 VALUATION OF ASSETS
• Tangible Assets: These assets are of a permanent nature with
the business is carried on and which are held for the purpose
of earning income and not for re – sale in the ordinary course
of the business.
• They are constantly used for the production of goods are not
consumed in the very process of manufacture.
• The examples of Tangible Assets are:
 Plant
 Machinery
 Plant and Machinery
 Land and Building
 Furniture
 Fixtures
 Motor Car
 VALUATION OF ASSETS
• Intangible Assets: Those fixed or tangible assets which have
income producing ability but cannot be seen or touched are
known as intangible assets. These are –
 Goodwill
 Patents
 Copyrights
 Licences
 Trademarks
 Slogan
 Speech
 Formula
• They are generally valued in the same manner in which tangible
fixed assets are valued, i.e., to be valued at the cost price.
• If they are purchased, the expenditure incurred for acquiring them
would be considered as cost.
 CONCEPT OF VALUE
• Book Value: The value of an asset as shown in the books of
accounts of business concern.
• Market Value: The Price which can be realized by selling the
assets in the open market.
• Intrinsic Value: The value of an asset is equal to the present
value of incremental income future cash inflows likely to
accrue due to acquisition of the assets, discounted at the
appropriate required rate of return.
• Liquidation Value: The value represents the price at which
each individual asset can be sold if business operations are
discounted in the case of liquidation of the business.
• Replacement Value: The price which will be required to
purchase a similar new asset in the market to replace the old
asset.
 CONCEPT OF VALUE
• Salvage Value: The value at which an asset might be
sold as a scrap when it has to be discarded.
• Value of Goodwill: The value which is arrived by:
• Value of goodwill = Average Profits x Year’s of Purchase
• Value of goodwill = Super Profit x Year’s of Purchase
• Fair Value: The average of book value, intrinsic value
and market value is called the fair value.
• Cost Price: The price at which the asset was acquired, it
might have been purchased or constructed. It also
includes the cost of installation.
• Realizable Value: It can be computed as follows:
Market Price – Marketing Expenses.
 STOCK VALUATION METHODS
• The price of a share of stock is the total value of the
company divided by the number of shares outstanding
• Stock price by itself doesn’t represent firm value
– Number of shares outstanding
• Stock price is determined by the demand and supply for
the shares
• Investors try to value stocks and purchase those that are
perceived to be undervalued by the market
• New information creates re-evaluation
 STOCK VALUATION METHODS
Price-Earnings (PE) Method

– Apply the mean PE ratio of publicly traded competitors

– Use expected earnings rather than historical
– Equation:
Firm’s
Stock = Expected EPS x Mean industry PE ratio
Price
 STOCK VALUATION METHODS

Price-Earnings (PE) Method

• Reasons for different valuations

– Different earnings forecasts
– Different PE multipliers
• Different comparison or benchmark firms
• Limitations of the PE method
– Errors in forecast or industry composite
– Based on PE, which some analysts question
 STOCK VALUATION METHODS
Dividend Discount Method

– The price of a stock reflects the present value of the

stock's future dividends
• t = period
• Dt = dividend in period t
• k = discount rate


Dt
Price  
t 1 (1  k)
t
 STOCK VALUATION METHODS
Dividend Discount Method

• Relationship between DDM and PE Ratio for valuing

firms
– PE multiple is influenced by required rate of return of
competitors and their expected growth rate
– When using PE multiple method, the investor implicitly
assumes that k and g will be similar to competitors
 STOCK VALUATION METHODS
Dividend Discount Method

• Limitations of the Dividend Discount Model

– Potential errors in estimating dividends
– Potential errors in estimating growth rate
– Potential errors in estimating required return
– Not all firms pay dividends
• Technology firms
• Biomedical firms
 STOCK VALUATION METHODS
Dividend Discount Method

• Adjusting the Dividend Discount Model

– Value of stock is determined by
• Present value of dividends over investment horizon
• Present value of selling price at the end
– To forecast the selling price, the investor can estimate
the firm’s EPS in the year they plan to sell, then multiply
by the industry PE ratio
DETERMINING THE REQUIRED RATE OF
RETURN TO VALUE STOCKS
• Capital Asset Pricing Model (CAPM)
– Used to estimate the required return on publicly traded
stock
– Assumes that the only relevant risk is systematic
(market) risk
• Uses beta to measure risk rather than standard deviation of
returns

Rj = Rf + j(Rm – Rf)
DETERMINING THE REQUIRED RATE OF
RETURN TO VALUE STOCKS
Rj = Rf + j(Rm – Rf)
Capital Asset Pricing Model (CAPM)
– Estimating the risk-free rate and the market risk
premium
• Proxy for risk-free rate is the yield on newly
issued Treasury bonds
• The market risk premium, or (Rm-Rf), can be
estimated using a long-term average of
historical data.
DETERMINING THE REQUIRED RATE OF
RETURN TO VALUE STOCKS

Rj = Rf + j(Rm – Rf)

– Estimating the firm’s beta

• Beta measures systematic risk
• Reflects how sensitive individual stock’s returns are relative to
the overall market
• Example: beta of 1.2 indicates that the stock’s return is 20%
more volatile than the overall market
• Investor can look up beta in a variety of sources such as Value
Line or Yahoo! Finance (Profile)
• Computed by regressing stock’s returns on returns of the
market, usually represented by the S&P 500 index or other
market proxy
DETERMINING THE REQUIRED RATE OF
RETURN TO VALUE STOCKS
• Arbitrage Pricing Model
– Differs from CAPM in that it suggests a stock’s price is
influenced by a set of factors rather than just the return
on the market
– Factors may include things like:
• Economic growth
• Inflation
• Industry effects
– Problem with APT: factors are unspecified and must be
defined
 FACTORS THAT AFFECT STOCK PRICES
• Economic factors
– Interest rates
• Most of the significant stock market declines occurred when
interest rates increased substantially
• Market’s rise in 1990s: low interest rates; low required rates of
return
– Exchange rates
• Foreign investors purchase U.S. stocks when dollar is weak or
expected to appreciate
• Stock prices of U.S. companies also affected by exchange rates
 FACTORS THAT AFFECT STOCK PRICES
• Market-related factors
– January effect
– Noise trading
• Trading by uninformed investors pushes stock
price away from fundamental value
• Market maker spreads
– Trends
• Technical analysis
• Repetitive patterns of price movements
 FACTORS THAT AFFECT STOCK PRICES
• Firm-specific factors
–Expected +NPV investments
–Dividend policy changes
–Significant debt level changes
–Stock offerings and repurchases
–Earnings surprises
–Acquisitions and divestitures
 FACTORS THAT AFFECT STOCK PRICES
• Integration of factors affecting stock prices
• Evidence on factors affecting stock prices
– Fundamental factors influence stock prices, but
they do not fully account for price movements
• Smart-money investors
• Noise traders
• Excess volatility
• Indicators of future stock prices
– Things that affects cash flows and required
returns
– Variance in opinions about indicators
 ANALYSTS AND STOCK VALUATION
• Stock analysts interpret “valuation effect” of new
information for investors
• Analysts’ opinions impact stock buying/selling
• Analysts’ ratings seldom recommend sell
– Income of analyst may come from investment banking
side of business selling company shares
– Companies shun analysts who recommend “sell”
– Analyst may personally own shares of company
 ANALYSTS AND STOCK VALUATION, CONT.
• Analyst may obtain “new” information with
company executives in conference call
– Other investors are not privy to information
– Regulation FD (Fair Disclosure) from SEC requires
“release” of new significant information at the same
time as teleconference calls with analysts.
• Other analyst recommendations
– Value Line
– Investor’s Business Daily
THREE STEP PROCEDURE FOR VALUING
COMMON STOCK
1. Estimate the amount and timing of future cash
flows the common stock is expected to provide.
2. Evaluate the riskiness of the future dividends, and
determine the rate of return an investor might
expect to receive from a comparable risky
investment, which becomes the investor ’ s
required rate of return.
3. Calculate the present value of the expected
dividends by discounting them back to the present
at the investor’s required rate of return.
BASIC CONCEPT OF THE STOCK VALUATION
Example 10.1 Consider a situation in which we are
valuing a share of common stock that we plan to hold
for only one year. What will be the value of the stock
today if it pays a dividend of $2.00, is expected to
have a price of $75 and the investor’s required rate of
return is 12%?
BASIC CONCEPT OF THE STOCK VALUATION
Value of Common stock
= Present Value of future cash flows
= Present Value of (dividend + expected
selling price)
= ($2+$75) ÷ (1.12)1
= $68.75
BASIC CONCEPT OF THE STOCK VALUATION
Example 10.2 Continue example 10.1. What will be the
value of common stock if you hold the stock for two years
and sell it for $82? Assume the dividend payment is fixed
at $2 per year.
•Value of Common stock
= Present Value of future cash flows
= Present Value of (dividends + expected
selling price)
= {($2) ÷ (1.12)1 } + {($2+$82) ÷ (1.12)2 }
= $71.14
BASIC CONCEPT OF THE STOCK VALUATION
• Since stocks do not have a maturity period, we can
consider the value of stock to be equal to the
present value of future expected dividends over a
certain period and an expected selling price.

• Valuing common stocks using general discounted

cash flow model is made difficult as analyst has to
forecast each of the future dividends. This problem
is greatly simplified if we assume that dividends
grow at a fixed or constant rate.
 VALUATION CONCEPT
• A Security can be regarded simply as a series of
dividends or interest payment receivable over a
period of time.
• Therefore, value of any security can be defined as
the present value of these future cash flows.
Symbolically, it can be represented as
C1 C2 Cn
V0 = --------- + ---------- + -- +-------
( 1 + k )1 ( 1 + k )2 (1 + k)n
 CONCEPTS OF VALUE

• REPLACEMENT VALUE
• LIQUIDATION VALUE
• GOING CONCERN VALUE
• MARKET VALUE
 VALUATION OF BOND
• A bond represents a contract under which a borrower
promises to pay interest and principal on specific dates to
the holders of the bond.
• Bonds issued by the government or public sector
companies in India are secured and bonds issued by private
sectors may be secured or unsecured.
• Bonds issued by the central government are called Treasury
bonds.
• These are bonds which have maturities ranging from 3 to
20 years. These bonds generally pay interest semi-annually.
 VALUATION OF BOND
• State government bonds are issued by the state
governments. These bonds also have maturities that
generally range from 3 to 20 years and pay interest semi-
annually.
• Bonds issued by companies are classified into two types:
PSU bonds and private sector bonds. PSU bonds issued by
companies in which the central or state govts. have an
equity stake in excess of 50%.
• Private sector bonds are bonds issued by private sector
companies. Bonds issued by companies, PSU bonds as well
as private sector bonds, generally have maturity ranging
from 1 year to 15 years and pay interest semi-annually.
 BASIC BOND VALUATION MODEL
• For valuation of bond the following assumptions were to be made:
 The coupon interest rate is fixed for the term of the bond.
 The coupon payments are made annually and the next coupon
payment is receivable exactly a year from now.
 The bond will be redeemed at par or maturity.
• The cash flows for a bond comprises of an annuity of a fixed coupon
interest payable annually and the principal amount payable at
maturity. The value of the bond is:
n I F
V0 = Σ ------------ + -------------
t=1 ( 1 + r )t ( 1 + r )n
 BASIC BOND VALUATION MODEL
BOND VALUES WITH SEMI-ANNUAL INTEREST:
2n I/2 F
V0 = Σ ------------ + -------------
t=1 ( 1 + r/2 )t ( 1 + r/2 )2n

= I/2 ( PVIFAr/2,2n) + F ( PVIFr/2,2n)

ONE PERIOD RATE OF RETURN:
( Price gain or loss + ( Coupon interest
during holding period) if paid)
--------------------------------------------------------
( Purchase price at the beginning
of the holding period )
 BASIC BOND VALUATION MODEL
CURRENT YEILD:
Current yield measures the rate of return earned on
a bond if it is purchased at its current market price
and if the coupon interest is received.
Coupon Interest
Current yield = -----------------------------
Current Market Price
 YIELD TO MATURITY
• The yield to maturity (YTM) of a bond is the interest
rate that makes the present value of the cash flows
receivable from owning the bond equal to the price
of the bond.
n I F
V0 = Σ ------------ + -------------
t=1 ( 1 + r )t ( 1 + r )n
AN APPROXIMATION:
I+(F–P)
YTM = ----------------------
0.4 F + .06 P
 BOND VALUE THEOREMS
I. The effect on the bond values influenced by the relationship
between the required rate of return and the coupon rate.
i. When the required rate of return is equal to the coupon
rate of return, the value of the bond is equal to its par
value.
ii. When the required rate of return is greater than the coupon
rate, the value of the bond is less than its par value.
iii. When the required rate of return is greater than the coupon
rate, the value of the bond is greater than its par value.
II. The effect of the number of years to maturity on bond values.
i. When the required rate of return is greater than the coupon
rate, the discount on the bond declines as maturity
approaches.
ii. When the required rate of return is less than the coupon rate,
the premium on the bond declines as maturity approaches.
 BOND VALUE THEOREMS
III. The effect of the yield to maturity.
i. A bond’s price moves inversely proportional to its yield to
maturity.
ii. For a given difference between YTM and the coupon rate of
the bonds, the longer the term to maturity, the greater will
be the change in price with change in YTM.
iii. Given the maturity, the change in bond price will be greater
with a decrease in the bond’s YTM than the change in bond
price with an equal increase in the bond’s YTM.
iv. For any given change in YTM, the percentage price change
in case of bonds of high coupon rate will be smaller than in
the case of bonds of low coupon rate, other things
remaining the same.
v. A change in the YTM affects the bonds with a higher YTM
more than it does bonds with a lower YTM.