Valuation of Securities

Time value of money affects the valuation of

the securities
We apply the TVM concept to find out the
value of different types of securities
Different types of securities that will be
covered are
Debentures(Bonds)
Preference Shares
Equity Shares

Valuation of Securities
What is a Security?
A financial security is some type of financial
instrument that has a recognized financial worth
Usually referred to simply as securities, the financial
security can take on several forms
Generally, a financial security will have the potential
to generate some additional return above face value
in the future
Thus we can say that the value of a security is the
Present value of the future benefits associated
with it

Valuation of Securities
Symbolically
A= Future Annual cash flow
PVIFA = Present Value Interest Factor for Annuity
Value of Asset = A X PVIFA
An Investor expects an annual return of Rs 1000
for the next 10 years, find the current value of the
asset ,with interest rate of 15 %
Rs 5019

Valuation of Securities
Valuation of Debentures
In corporate finance, the term is used for a
medium- to long-term debt instrument used by
large companies to borrow money. In some
countries the term is used interchangeably with
bond, loan stock or note.

Valuation of Securities
Important terms associated with Debentures
Face Value: the amount on which the issuer pays interest,
and which, most commonly, has to be repaid at the end/
maturity. Generally it is RS 100 or RS 1000.
Coupon :the interest rate that the issuer pays to the bond
holders. Usually this rate is fixed throughout the life of the
bond
Maturity Date : the date on which the issuer has to repay the
FV.As long as all payments have been made, the issuer has
no more obligation to the bond holders after the maturity
date. The length of time until the maturity date is often
referred to as the term or tenor or maturity of a bond.

Valuation of Securities
Debentures Valuation Model
An investor of debenture is entitled to get the following two
things
Interest at a fixed rate till maturity
Principal amount of the debenture on its maturity

Vd= PV of all the future Interest inflows+ PV of the FV paid at the maturity
Vd = PVIFA X Annual Interest Payment+ PVIF X Face Value

Valuation of Securities
A debenture of with FV = Rs 100 carrying an interest rate @
15 % will mature in 5 years. The required rate of return of
this debenture is 10%.Calculate the PV of the debenture.
Annual interest inflow = Rs 15
Face Value inflow at maturity = Rs 100
PVIFA ( 5 years,10%) =3.791
PVIF(5 years,10 %) =.621
PV of the Debenture = 3.791*15+.621*100
Rs 118.965

Valuation of Securities
Relation between the Interest Rate(Coupon Rate) and the
Required Rate of Interest( discount rate)
Coupon Rate can be denoted by c
RRI(Discount Rate) can be denoted by k
Conditions
Let Face Value of the Bond = Rs 1000
Let k = c =15% , Recalculate the value of the debenture?
Let k = 12 % and c = 15 % Recalculate the value of the
debenture?
Let k = 15 % and c = 12 % Recalculate the value of the
debenture?

Valuation of Securities
Conditions
Let k = c =15% , Recalculate the value of the debenture?
Vd =1000 (k = c)

Let k = 12 % and c = 15 % Recalculate the value of the

debenture?
Vd =1108 ( k < c)

Let k = 15 % and c = 12 % Recalculate the value of the

debenture?
Vd = 900 ( k > c)

Valuation of Securities
Semi-Annual Interest Rate and Valuation of the bond
This is the case when the interest is payable semi-annually (
twice in 1 year)
To calculate the value of the Bond

Divide the coupon rate (c )by 2

Divide the required rate of return(k) by two
Multiply the maturity period by 2
Do the calculations as before for the annual compounding

Valuation of Securities
Mr. A holds the debenture with face value of Rs
1000 carrying an interest rate of 12 % pa. The
interest is payable semi-annually. The required rate
of return is 16% pa. The debenture is payable at a
premium of 10 % after 8 years. Calculate the value
of debenture

Valuation of Securities
Face Value= Rs 1000
Coupon Rate = 6% (12/2)
RR =8% (16/2)
Maturity Period 16 years (8X2)
PVIFA (16 years,6%)=10.106
PVIF( 16 Years,4%) =.292
Vd= 10.106 X 60 + .292 X1100
Rs 927.56

Valuation of Securities
Valuation of perpetual debenture
A debenture that never matures
Rarely found in practice
Vdp = Annual Interest Payment/Required rate of Return
Example : A debenture holder is to receive an annual interest @10 %
for perpetuity. The face value of the debenture is Rs 1000.Calculte the
Value of the debenture if the required rate of return is:
1. 15%
1.

2.

8%
1.

3.

Rs 667
RS 1250

10%
1.

RS 1000

Valuation of Securities
Yield To Maturity( YTM)
That interest rate at which the Value of the debenture
become equal to its market price.

Example:
A companys debenture has a face value( par value) of Rs 1000,
and carry an interest rate of 9% and matures in 8 years. If the
current price of the bond in the market is Rs 800 would you buy
the bond? Discount rate is 10 %.
What is the YTM?

What is YTM of this bond

800 = 890 /(1+r)t + 1000/(1+r)8
t=1

YTM is nothing but r which equates its value to its MV

Valuation of Securities
How to calculate( YTM)
YTM = Annual Interest Payment + (F-P)/n
(F+P)/2
F = Face Value
P= Present Value of Debenture(Market Value)
n = Maturity period of debenture
YTM = 90+ (1000-800)/8
(1000+800)/2
= 115/900 = 12.70 % > Required Rate of Return

Simply put the annualized return an investor would get by

holding a fixed income instrument until maturity

Valuation of Securities
Example: Current Market Price of a a perpetual bond Rs
95(Face value is Rs 100).Coupon Rate is 13.5%.The Required
Rate of Return is 15 %.Calculate its intrinsic value. Should it
be bought?
What is it YTM?
Solution
Intrinsic Value( Fair Value) =13.5/.15 =RS 90
YTM for a perpetual bond =(Annual Interest Inflow/Market Price )X100
YTM= 14.2% <Required Rate of Return

Valuation of Securities
Preference Shares
Carry a fixed dividend and thus their valuation can be
done on the same basis as the bonds
Two types of preference shares
Redeemable
Both annual dividend and a maturity amount is payable

Irredeemable
Only annual interest is payable

Valuation of Securities
Valuation of Redeemable Preference Shares
Two Components
Annual dividend Cash inflow
Amount at maturity

Vd = PVIFA X Annual dividend Payment+ PVIF X Amount

payable at maturity
Example: Face value of Preference Share= Rs 100,Dividend
rate = @ 10%,Current Market Interest Rate =15%,Maturity =
15 Years
PVIFA =5.019, PVIF = .247,
VPS = Rs 74.89

Valuation of Securities
A pref share of RS 1000 carries a dividend rate of 10 %.The
current market interest rate is 15%.The preference share
becomes due for redemption in 10 years. Find the value of
the pref share.
Rs 748.90

Valuation of Securities
Valuation of Irredeemable Preference Shares
Single Component
Annual dividend Cash inflow
Value = annual dividend cash inflow/Current Yield

Example :Face value of Preference Share= Rs 100.Dividend

rate = @ 10%.Current Yield on the preference share =15%
VPS = 10/.15 = Rs 67
Yield on the preference share can be calculated on the same
patterns as calculated for the Debentures
Example: Current market price of a irredeemable pref share is Rs 80. Annual
dividend flow is Rs 10. Calculate the yield.
Fair value = Annual Dividend/k
Market Values = Annual Dividend/Yield
12.5%

Valuation of Securities
Equity Shares
The valuation of securities is difficult as compared to
valuation of debentures and Preference shares. Why?
There is no fixed dividend associated with the equity
The dividends are expected to grow at a steady rate unlike in the case
of debenture and preference shares

Two approaches to valuation of equity shares

Dividend capitalization Approach
Earning Capitalization Approach

Valuation of Securities
Approaches to valuation of equity shares
Dividend Capitalization
Approach

Growth in
Dividends

No Growth in
Dividends

Multiple Period

Constant Growth

Earning Capitalization
Approach

Single Period

Variable Growth

Multiple Period

Valuation of Securities
Dividend capitalization Approach
Capitalize the future dividend flow
Discount all the future cash inflows

DCA approached is based on the following

assumptions
Dividends are paid annually
The dividend is received after the expiry of a year of the
purchase of the equity share

Valuation of Securities
DCA approached again divided in to following two
categories
No growth in Dividends
Single period approach
Multiple Period approach

Growth in Dividends
Constant growth on year to year basis
Variable growth in dividends On year to year basis

Valuation of Securities
DCA Approach (No growth in Dividends)
Single period approach
The investor is presumed to hold the share for 1 year only
In such cash the cash inflow for the investor are
Dividend that will come after 1 year
The Price of the share that he/she may get after 1 year

Fair value of the share

PV of the Dividend + PV of the market Price of share after 1 year
P= D1 + P1
(1+k)1 (1+k)1

Valuation of Securities
Example
Mr. A holds an equity share giving him an annual
dividend of Rs 20.He is expected to sell the share at
Rs 180 after 1 year. Calculate the value of share at
present .The required rate of return(discount rate) is
12 %
P= D1 + P1
(1+k)1 (1+k)1
P= 20 + 180
(1+.12)1 (1+.12)1

Rs 178.57

Valuation of Securities
DCA Approach (No growth in Dividends)
Multiple period approach
The investor is presumed to hold the share beyond 1 year
for an unspecified no of years
Equity shares dont have any maturity period
One can expect the dividend cash inflow for infinite
period
This kind of cash flow is similar to the cash flow of a
Perpetual Debenture( one with no Maturity)
So valuation can be done in the similar way

Valuation of Securities
DCA Approach (No growth in Dividends)
Multiple period approach
Po= Expected annual dividend
Discount Rate
Po=
D
K

Example: A company is paying an annual dividend of Rs 40 per share.

The company is expected not to deviate from this dividend amount in the
future. Current discount rate is 15 %.Calculate the Present value of the
share
Po= D
= 40/.15= Rs 267
K

Valuation of Securities
DCA Approach ( Growth in Dividends)
The assumption of constant dividend without any growth is unrealistic as
companies grow over time
So growth in dividends needs to be incorporated
The model changes if the growth in the dividend is also taken care of

Valuation of Securities
DCA Approach (Constant Growth in Dividends)
P0 = D1
(k-g)
D1= Dividend at the end of second year
k = discount rate
g = growth rate of dividends( in %)
The above formula can also be written as
P0 = Do(1+g)
(k-g)

Valuation of Securities
Example:
ABC limited is expected to pay a dividend of Rs 40 per share. The dividends
are expected to grow at a rate of 10%.The capitalization rate is 15%.Find the
value of the share.

D1 = Rs 40
g = 10%=.10
K = 15% = .15
P0 = D1
kg
= Rs 800

Valuation of Securities
More Example
A share has current price of Rs 10 and is expected to earn a dividend of
Rs 2.The share will be sold at Rs 18 after 1 year. Find out the value of the
share if the capitalization rate(discount rate) is 12%
Which Model
No growth Model Single Time period
P = .893X 2+.893X 18= Rs 17.86
XYZ is paying a dividend of Rs 4 per equity share. This same rate of
dividend is going to continue for the coming years. T he discount rate is
12 %.Find out the value of the share?
Which Model
no growth Model Multiple Time period
P = D/k = 4/.12= Rs 33.34

Valuation of Securities
More Examples
A share is expected to earn a dividend of Rs 50.Dividend are expected to
grow perpetually at a constant growth rate of 8%.You are required to find
out the value of the share if the capitalization rate(discount rate) is 15%.
Which Model
constant growth Model Multiple Time period

P0 =

D1
(k-g)

50/(.15-.08)
Rs 714.28

Valuation of Securities
Variable Growth -Multiple time Period
The Dividends on the company share may not grow
at a constant rate
Two Stage Dividend growth model
Companies have years of super-normal growth where the
dividends grow at a very high rate
After this super-normal growth period the dividends grow
at a lower rate
1 -5 year---
g=10%
6th year onwards--g = 6%

Two Stage Model

10 %

g
6%

Time

Valuation of Securities
Using Two Stage Growth Model
A company is expected to pay a dividend of Rs 4 per
share after a year. Its dividends are expected to
grow at a rate of 15 % for the next 5 years and then
at a rate of 8% indefinitely. Find out the present
value of the share if the capitalization rate is 12 %

Timeline for Supernormal Growth

1

g = 15%
4.00
3.57

g = 15%

4.60

g = 15%
5.29

6.08

g = 15% g = 15%
7.00

g = 8%

8.04

PV

3.67

PV
PV

PV

3.77
3.87
3.97
PV4

3.08

Total = Rs 21.93
37

Valuation of Securities
Computation after 6th Year( Period of stable
growth
What is the dividend after 6th year
8.04

Dividend after 7th Year

8.04(1.08)= Rs 8.694

Lets assume I go in to future and I am at the

beginning of the 6th Year. What is the value of the
share at the starting at 6th Year?
D7/ k-g
= Rs 8.694/(.12-.08) = Rs 217.35

Valuation of Securities
What is the Present value of P6 today
217.35 X PV factor( 6 years,12%)
217.35X .507 = Rs 110.20
Present value of the share
Rs 110.20+ Rs 21.93
Rs 132.13

Can not apply Gordon model for first 6 years

g>k
g changes after 6th year

Valuation of Securities
Example
A ltd is expected to pay dividend of Rs 2 after the
end of the year. Dividends are expected to grow at a
rate of 20% for the next 4 years. After wards
dividends will grow only at 5%.The discount rate of
return is 12 %.Find the Present value of the share
Rs 49.07

Earning capitalization Approach

Po = E1/k
E1= earnings of the company after 1 year
Example
Calculate the price of the equity share as per the
ECA

Earnings per share(EPS) = Rs 10

K= 12%
Retained Earnings =0
P0 = 10/.12 = Rs 50

Earning capitalization Approach

Calculate the price of the equity share as per the

DCA
Earnings per share(EPS) = Rs 10
K= 12%
Retained Earnings =0

When the company is not retaining any earnings it

means that everything is distributed as dividends
So D1= Rs 10, k = 12%, g=0,
P0 = D1/k
P0 = 10/.12 = Rs 50