Valuation

1. Valuation

2. 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

3. Valuation of Bonds and Shares • It is the process of linking risk with returns to determine worth of an assets which can be real or financial. • In order to achieve individual’s goal of profit maximization one has to constantly monitor the investments. • So the value of an asset depends upon the cash flow it is expected to provide over the holding period.

4. Concept of valuation • Security can be evaluated by series of dividends or interest payment received over a period of time. • So, it can be valued by taking PV of future cash flow associated with it which is also called as an intrinsic value. • The expected returns are discounted using required rate of return to commensurate with risk.

5. 0 1 2 n k ... Value CF1 CF2 CFn The value of financial assets

6. Example 1 • With a rate of 8% and the cash flows associated with project A, B and C are for 3 years are as follows. At the end of the three year which project should be continued ? year Cash flows A B C • 10000 15000 4000 • 10000 7000 8000 • 10000 8000 18000

7. PV of A = 10000* PVIFA (8%, 3 YEAR) = 10000*2.577 = 25770 • PV of B = 15000*PVIF (8%, 1 Yr) + 7000 * PVIF(8% , 2 Yr) + 8000* PVIF (8%, 3 Yr) = 15000*.926 + 7000*.857+8000*.794 = 13980+5999+6352 = 26331 • PV of C = 4000 *PVIF (8%, 1 Yr) + 8000 * PVIF(8% , 2 Yr) + 18000* PVIF (8%, 3 Yr) = 24582 • So, Project B should be selected.

8. Several Kinds of “Value” • There are several types of value, of which we are concerned with three: • Book Value - The asset’s 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 maker’s required rate of return

9. Other value • Replacement Value - Amount a company is required to spend to replace its existing assets in the present condition. • Liquidation Value – Amount a company can realize if it sold the assets if it is winding up its business. It is the minimum value the company might accept to sold its business • Going Concern Value – Amount a company get its current operating business. i.e. machinery . This value is generally higher than liquidation value.

10. Valuation of Bonds • A long-term debt instrument (a legal contract) in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond. • It is generally issued by government agencies or corporate houses to raise money. • It can also be issued by private or public company. • The rate of interest on bonds are fixed.

11. Definitions • Par or Face Value - The amount of money that is paid to the bondholders at maturity. For most bonds this amount is Rs. 100 or 1,000. It also generally represents the amount of money borrowed by the bond issuer. • Coupon Rate -The coupon rate, which is generally fixed, determines the periodic coupon or interest payments. It is expressed as a percentage of the bond's face value. It also represents the interest cost of the bond to the issuer. It is paid at the regular intervals.

12. Key Features of a Bond • Maturity Date - The maturity date represents the date on which the bond matures, i.e., the date on which the face value is repaid. The last coupon payment is also paid on the maturity date. • Issue date – when the bond was issued. • Redemption Value - amount the bond holder gets on maturity. It may be redeemed at par, at a premium (< par value), or at discount (> par value) • Market value – the price at which the bond can be bought and sold it may be different from par or redemption value.

13. Bond Valuation • Bonds are valued using time value of money concepts. • Their coupon, or interest, payments are treated like an equal cash flow stream (annuity). • Their face value is treated like a lump sum. • Bonds with annual interest payments • Bonds with semi-annual interest payments

14. Bonds with annual interest payments • Here holder receives a fixed annual interest for a specified number of years and fixed principle at maturity. • So value of such Bond is PV of interest it paid and PV of principle amount. • V0 = I*PVIFA (kd, n) + F* PVIF (Kd, n)

15. Holding Period rate of return • If a bond is purchased and then held for a year and after a year it is sold. So find the single holding period return • [(price gain/loss during holding period) + (coupon interest on actual price)] / Purchase price at the start of holding period. • If the price of bond falls by amount higher than coupon interest, the rate of return is negetive.

16. Example 7 • Mr. A buy bond of 1000 rs. With 10% coupon rate in 800 rs. Later after one year he sold bond in 600 rs. Find rate of return to A for one year. • Coupon payment = 10% of 1000 = 100 • Amount of purchase is 800 • (-200 + 100)/ 800 = -25 %

17. Current Yield • It is the rate of return earned on a bond if it is purchased at its current market price and coupon interest received. • Current yield (CY) = coupon interest / current market price • I.e. calculate CY of 8% coupon rate of 1000 rs. Bond with current mkt price is 920. = 80 / 920 = 8.7 %

18. Yield to maturity (YTM) The rate of return that an investor would earn if he bought the bond at its current market price and held it until maturity.

19. Example 10 • Find the YTM of a bond with a par value of 500 Rs. Which is traded at rs. 435. the coupon rate is 12% and maturity period is 7 years. • F=500, P = 435, I = 60, n = 7 • So, YTM = {60 + (500 – 435)/7 }/ {(500+435)/2} = 14.81 (Coupon+Par value-traded value/par value+Traded value/2)

20. Valuation of Shares • Shares may be of two categories • Ordinary/equity share holders • Preference Share holders. • The return shareholders get are called as dividends. • Some of the important features of both shares and difference between both shares are described.

21. Valuation of Ordinary Shares • The common reason for holding the equity shares are • To obtain cash inflow in form of dividend • To obtain capital gain i.e. higher amount when it sold. • So At the time of selling share, all future cash streams in form of dividend are also sold. • So the value of share can be determined by capitalizing all this cash flows at appropriate interest rate. • Under this method the value of share is the discounted pv of dividend received and pv of expected resale price of share. This method is called as dividend capitalisaiton approach. • Here two assumptions are made for dividend. • Dividends are paid annually. • First dividend made after first year of share bought.

22. Single Period Valuation Model • Under this period an investor keep stock for one year and after one year he/she will sell it. Po = [D1/ (1+ke)] + [P1 / (1+ke)] Po = current market price D1= expected dividend after one year Ke= required rate of return on equity share P1= Expected resale price.

23. Example 13 • Share of BHEL is expected to touch rs. 2100 after one year and company is expected to give dividend of 50 rs. Per share. Calculate the price of an investor should pay if required return is 12%.

24. Multi period dividend model • Constant dividend. • Constant growth of dividend. • Changing growth of dividend.

25. Multi-period valuation model/Constant dividend model • Assuming an investor would not sell the stock and keep the stock for infinite time period. • In this case he would only get dividend and value of share can be found out by finding PV of all dividend. Here assuming dividend is constant. Than Po = D / Ke

26. Example 14 • Mr. A would like to keep with him share of reliance industry life time knowing that it would give at least 50 Rs. Dividend every year. What should be the price of reliance industry? If required rate of return is 14%.

27. Constant growth model • Here dividend is growing for infinite time period with constant growth ‘g’.It is also growing at compounded rate. • With the required rate of return Ke, the value of the share should be.

28. D1 (Ke - g) P0 = Constant Growth Model if following conditions are met. 1. g is constant 2. Ke > g

29. Non constant/ changing growth in dividend • Companies may pay high dividend in the time of high profitability and may reduces due to fall in demand of product. • During the high dividend period is called as super annual growth period.

30. Other approaches to the valuation • Book Value Approach • BV per Share = Net worth (Total Assets - Total Liabilities)/ outstanding equity shares • Example: Total Assets = $10 million; Total Liabilities = $4 million; number of common stock shares outstanding = 3 million • BV per share = ($10million - $4million)/3 million = $2.00 per share

31. The End