Blackbook Valuation

TYBFM VALUATION OF SECURITIES
CHAPTER I
INTRODUCTION
1.1 INTRODUCTION TO VALUATION OF SECURITIES

An investment is defined as a commitment of funds to derive a return that would
compensate the investor for the time during which the funds are invested, for the
expected rate of inflation over the investment horizon, and for the uncertainty involved.
From this definition, we know that the first step in making an investment is determining
the required return.
Most investments have expected cash flows and a stated market price (e.g., common
stock), and it must estimate a value for the investment to determine if its current market
price is consistent with your estimated intrinsic value. Intrinsic value must be estimated
of the security based on its expected cash flows and your required return.
The two general approaches to the valuation process:
(1) The top-down, three-step approach; or
(2) The bottom-up, stock valuation, stock-picking approach. The difference between the
two is the perceived importance of the economy and a firm’s industry on the valuation of
a firm and its stock. Both can be implemented by either fundamentalists or technicians.
Advocates of the top-down, three-step approach believe that both the economy/market
and the industry effect have a significant impact on the total returns for individual stocks.
In contrast, those who employ the bottom-up, stock-picking approach contend that it is
possible to find underrated stocks relative to their market price, and these stocks will
provide superior returns regardless of the market and industry outlook.
Both of these approaches have numerous supporters, and advocates of both approaches
have been quite successful. Although we believe that a portfolio manager or an investor
can be successful using the bottom-up approach, we believe that it is more difficult to be
successful because these stock pickers ignore substantial information from an analysis of
the outlook for the market and the firm’s industry.
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1.2 OBJECTIVES OF THE STUDY
The objectives of the research are:
 To study valuation of securities in context to investments.

 To study a price-earnings (Whitbeck-Kisor) valuation model in context of the
Indian stock market
 To evaluate the Capital Asset Pricing Model (CAPM) in context of the Indian
stock market
 To develop and test the customized valuation model
 To test the efficiency of the Indian stock market (All three forms
 To find the impact of Efficiency Market Hypothesis (EMH) on valuation models
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1.3 SIGNIFICANCE OF THE STUDY
The stock market of India has gone through a series of revolutionary changes since
economic liberalization commenced in 1991. The changes were necessary to transform
Indian stock market into a more efficient one. Earlier, the stock market of a developing
country like India was characterized by extensive governmental regulation over its
financial system and investment activities. Moreover, it was an underdeveloped capital
market which was influenced by:
Restriction on capital structure
Fewer instruments
Rationing of commercial bank credit
Restriction on investment opportunities
Underdeveloped securities market
Uncertainty in supply of funds
Complex bureaucracy and regulatory norms
Therefore, there is a need to test valuation models and to develop a customized model in
the context of the Indian stock market in the post-liberalization era. This research also
carried out tests of efficiency in the context of the Indian stock market to measure the
degree of strength and maturity.
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1.4 LIMITATIONS OF THE STUDY
 The Sample size was very limited to 100 Investors it may or may not be
represented with the entire population..
 The survey is conducted only in Mumbai City. So, it provides idea of that
particular region investment pattern and their preference only.
 Scope of the study is limited to the selected investment instruments only.
The total number of financial instruments is so large that it needs a lot of resources to
analyse them all. There are various companies providing these financial instruments
to public. Handling and analysing such a varied and diversified data need a lot of time
and resources.
 Reluctance of the people to provide complete information about them can affect
the validity of the responses.
1.5 SCOPE OF THE STUDY
The research will throw new insights into the Indian stock market and its behavior. Stock
market has undergone a series of changes and it is necessary to test the market efficiency
since most of the tests were conducted in context of a developed economy. Moreover, a
customized stock valuation model will also help to identify the factors that drive the stock
price in the Indian stock market in the post-liberalization era.
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1.6 METHODOLOGY
TYPE OF RESEARCH: Descriptive and random sampling research
RESEARCH DESIGN: A Research design is purely and simply the framework of plan
for a study that guides the collection and analysis of data. The study is intended to find
the investors preference towards various investment avenues. The study design is
Descriptive in nature. Descriptive Research is a fact-finding investigation with adequate
interpretation. It is the simplest type of research and is more specific. Mainly designed to
gather descriptive information and provides information for formulating more
sophisticated studies.
SOURCE OF DATA: Secondary data collected from various books, Journals, magazines
& websites etc. The Personal Factors such as gender, qualification and work status, and
income and life stage are analyzed through a structured questionnaire
TYPE OF SAMPLING: Convenience method of sampling is used to collect the data from
the respondents. Researchers or field workers have the freedom to choose whomever they
find, thus the name “convenience”.
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CHAPTER 2
REVIEW OF LITERATURE
1. A Kane (2018) had made an evaluative study of the New Issue Market (NIM) for
the period 2013-2018 The role of the financial institutions in the NIM has been
described and evaluated. The study shows that a new class of middle - income
individual investors has emerged as an important supplier of the risk capital
2. Gupta (2016) in his book has studied the working of stock exchanges in India and
has given a number of suggestions to improve its working. The study highlights
the' need to regulate the volume of speculation so as to serve the needs of liquidity
and price continuity. It suggests the enlistment of corporate securities in more
than one stock exchange at the same time to improve liquidity. The study also 22
wishes the cost of issues to be low, in order to protect small investors.
3. E Becalli ( 2016) states that the basic function of the stock market is to provide
ready marketability or liquidity to holdings o: securities. The ideal stock market is
one that can provide instantaneous and unlimited liquidity. But it is reasonable to
assume that a prudent long-term investor in equities would provide for his
immediate cash needs. This is in agreement with the three motives of liquidity
preference. If so, one would expect not `instant' liquidity, but moderate liquidity.
It will be unreasonable for any investor to suppose that his equity holdings are as
good as cash.
4. Mc Kinnon and Shaw (2015) advocate liberalisation of financial market,. They

argue that state intervention in setting interest rates and quantitative measures of
resource allocation adversely affect, not only allocative efficiency but also
depress the aggregate saving rate in less developed economies
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5. Bain and Company (2015) examines the role, and the cost of raising funds from the
market. The study goes on to suggest appropriate measures to enable the NIM to play
a part in consonance with the requirements 23 of the planned growth of industry. The
core of the study deals with the new issues and company finance , the structure of
underwriting, and the cost of capital . The study has important policy implications in
terms of its relevance to the national economy. In the process of industrialisation, a
developed NIM would be instrumental in forging an organic link between the
collection and distribution of industrial capital
6. Blume and Friend (2014) state that the proportion of stock owned by institutional
investors in America has increased sharply, while that owned by individual investors
has decreased. They analyse the effects of the shift in stock ownership from
individuals to institutions on the efficiency of equity market. They also examine, the
pros and cons of numerous proposals for improving the securities market.
Transactions by individuals have always been regarded as essential to both liquidity
and the efficiency of the market.
7. Panda (2014) has studied the role of stock exchanges in India before and after
independence. The study reveals that listed stocks covered four-fifths of the joint
stock sector companies. Investment in securities was no longer the monopoly of any
particular class or of a small group of people . It attracted the attention of a large
number of 24 small and middle class individuals. It was observed that a large
proportion of savings went in the first instance into purchase of securities already
issued.
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8. Chitale (2013) in his work has evaluated the underlying causes of the growing
shortage of equity finance for funding new industrial enterprises in the private sector
during the period 2010-2012. The available evidence suggests the emerging scarcity
of risk finance, despite bullish trend in the price of select shares and over - sub
scrimping to a few issues of good companies. The study also evaluates the quantum
and the kind of returns that investors were able to earn from their investments in
equity shares of new companies.
9. Bajpai (2013) establishes that, the liquidity aspect is an essential constituent of an

efficient stock market, a sub-system of capital market. The growth of the equity cult
in the 2000s was supported by the actual experience of the Indian investors. Equity
prices between 2000 and 2013 have outperformed other popular avenues of
investment
10. Bhole (2012) in his paper, finds that various categories of people in India have
become preoccupied, rather obsessed with, the industrial securities market since the
middle of the 1980s, particularly since the launching of the New Economic Policy
(NEP) in the middle of 1991. The stock ma-k,t has been regarded and projected as the
barometer of the heal-'1 of the economy. The essentiality of the growth or spread of
equity culture or equity cult is being constantly stressed. Though the stock market
activity has been subject to wide fluctuations, the long-term trend has been one of
steep increase. . The investors' asset preference has somewhat shifted from deposits to
industrial securities.
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Books -The Indian Capital Market at Crossroads

Equity Asset Valuation
Valuation Of Securities
http://www.businessmanagementideas.com/financial-
management/valuation/valuation-of-securities-with-formula/3856
https://jpm.iijournals.com/content/25/3/25
https://www.researchgate.net/publication/5189934_The_Valuation_of_Securi
ty_Analysis
https://www.researchgate.net/publication/5189934_The_Valuation_of_Securi
ty_Analysis
Research Gap:
Based on the literature review, the following research gaps have been identified: We did
not find any references to substantiate that Whitbeck-Kisor model has been tested in the
Indian stock market during the post- liberalization era. Several tests have been conducted
regarding the validity of Capital Asset Pricing Model (CAPM) by the researchers in
Indian stock market, however, the results were found to be dichotomous. Despite failure
of earlier studies, very little introspection made into the causal effect which was missing
in the existing literature. Existing literature have tend to view ‘valuation models’ and
‘Efficient Market Hypothesis’ are two mutually exclusive and independent fields of study
In view of the above, an attempt has been made in this research to indicate ‘Efficient
Market Hypothesis’ as a possible causal effect.
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CHAPTER 3
CONCEPTUAL FRAMEWORK
Investment process invariability requires the valuation of securities in which the

investments are proposed. A number of concepts of valuation has been used in the
literature. Some of these are:
1. Book Value (BV)BV of an asset is an accounting concept based on the historical data
given in the balance sheet of the firm. BV of an asset may either be given in the balance
sheet or can be ascertained on the basis of figures contained in the balance sheet. The BV
of an equity share can be ascertained by dividing the net worth of the firm by the number
of equity shares.
2. Market Value (MV). MV of an asset is defined as the price for which the asset can be
sold. MV of a financial asset refers to the price prevailing at the stock exchange. In case a
security is not listed, then its MV may not be available.
3. Going Concern Value (GV). GV refers to the value of the business as an operating,
performing and running business unit. This is the value which a prospective buyer of a
business may be ready to pay. GV may be less than or more than the MV/BV of the total
business. Rather, GV depends upon the ability to generate sales and profit in future. If the
GV is higher than the MV, then the difference between the two represents the synergies
of the combined assets.
4. Liquidation Value (LV). LV refers to the net difference between the realizable value
of all assets and the sum total of the external liabilities. This net difference belongs to the
owners/shareholders and is known a LV. The LV is a factor of realizable value of an
asset and therefore, is uncertain. The LV may be zero also and in such a case, the
owners/shareholders do not get anything if the firm is dissolved.
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5. Capitalized Value (CV). CV of a financial asset is defined as the sum of present value
of cash flows from an asset discounted at the required rate of return. In order to find out
the CV, the future expected benefits are discounted for time value of money. In the
valuation of financial assets, the CV is most relevant concept of valuation and has been
used in this text. Required Rate of Return. In order to find out the CV, what is required is
the determination of the required rate of return of the investor for the specific security
being valued.
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CHAPTER 4
AN OVERVIEW OF SECURITIES MARKET
Securities market is a component of the wider financial market where securities can be

bought and sold between subjects of the economy, on the basis of demand and supply.
Securities market encompasses equity markets, bond markets and derivative
markets where prices can be determined and participants both professional and non-
professionals can meet .Securities markets can be split into two levels. Primary markets,
where new securities are issued and secondary markets where existing securities can be
bought and sold. Secondary markets can further be split into organized exchanges,
such stock exchanges and over-the-counter where individual parties come together and
buy or sell securities directly. For securities holders knowing that a secondary market
exists in which their securities may be sold and converted into cash increases the
willingness of people to hold stocks and bonds and thus increases the ability of firms to
issue securities.
There are a number of professional participants of a securities market and these
include; brokerages, broker-dealers, market makers, investment managers, speculators as
well as those providing the infrastructure, such as clearing houses and securities
depositories.
A securities market is used in an economy to attract new capital, transfer real assets in
financial assets, determine price which will balance demand and supply and provide a
means to invest money both short and long term.
A securities market is a system of interconnection between all participants (professional

and nonprofessional) that provide effective conditions:
1. To transfer real asset into financial asset,

2. To invest money for short or long term periods with the aim of deriving profitability.
3. Commercial function (to derive profit from operation on this market)
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4. Price determination (demand and supply balancing, the continuous process of price
movements guarantees to state correct price for each security so the market corrects
mispriced securities)
5. Informative function (market provides all participants with market information about
participants and traded instruments)
6. Regulation function (securities market creates the rules of trade, contention regulation,
priorities determination)
7. Transfer of ownership (securities markets transfer existing stocks and bonds from
owners who no longer desire to maintain their investments to buyers who wish to
increase those specific investments.
8. Insurance (hedging) of operations though securities market (options, futures, etc.)
Equity securities
Equity can have somewhat different meanings, depending on the context and the type of
asset. In finance in general, you can think of equity as one’s degree ownership in any
asset after all debts associated with that asset are paid off. For example, a car or house
with no outstanding debt is considered entirely the owner's equity because he or she can
readily sell the item for cash, and pocket the resultant sum. Stocks are equity because
they represent ownership in a firm, though ownership of shares in a public
company generally does not come with accompanying liabilities.
The following are more specific definitions for the various forms of equity:
1. A stock or any other security representing an ownership interest. This may be in a

private company (not publicly traded), in which case it is called private equity.
2. On a company's balance sheet, the amount of the funds contributed by the owners (the
shareholders) plus the retained earnings (or losses). Also referred to as stockholders'
equity or shareholders' equity .
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3. In the context of margin trading, the value of securities in a margin account minus

what has been borrowed from the brokerage.
4. In the context of real estate, the difference between the current fair market value of the
property and the amount the owner still owes on the mortgage. It is the amount that the
owner would receive after selling a property and paying off the mortgage. Also referred
to as “real property value.”
5. In terms of investment strategies, equities are one of the principal asset classes. The
other two are fixed-income (bonds) and cash/cash-equivalents. These are used in asset
allocation planning to structure a desired risk and return profile for an investor's portfolio.
6. When a business goes bankrupt and has to liquidate, the amount of money remaining

(if any) after the business repays its creditors. This is most often called “ownership
equity” but is also referred to as risk capital or “liable capital.”
Debt securities
Debt security refers to a debt instrument, such as a government bond, corporate bond,
certificate of deposit (CD), municipal bond or preferred stock, that can be bought or sold
between two parties and has basic terms defined, such as notional amount (amount
borrowed), interest rate, and maturity and renewal date. It also includes collateralized
securities, such as collateralized debt obligations (CDOs), collateralized mortgage
obligations (CMOs), mortgage-backed securities issued by the Government National
Mortgage Association (GNMAs) and zero-coupon securities.
The interest rate on a debt security is largely determined by the perceived repayment
ability of the borrower; higher risks of payment default almost always lead to higher
interest rates to borrow capital. Also known as fixed-income securities, most debt
securities are traded over-the-counter.
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CHAPTER 5
THEORY OF VALUATION
You may recall from your earlier studies that the value of an asset is the present value of
its expected returns. This process of valuation requires estimates of (1) the stream of
expected returns and (2) the required return on the investment (its discount rate).
1-Stream of Expected Returns (Cash Flows) Estimating an investment’s expected
returns encompasses not only the size but also the form, time pattern, and uncertainty of
returns, which affect the required return.
Form of Returns Investment returns can take many forms, including earnings, cash
flows, dividends, interest payments, or capital gains (increases in value) during a period.
We will consider several valuation techniques that use different forms of returns. For
example, one common stock valuation model applies a multiplier to a firm’s earnings,
another model computes the present value of a firm’s operating cash flows, and a third
model estimates the present value of dividend payments. Returns or cash flows can come
in many forms, and you must consider all of them to evaluate an investment.
Time Pattern and Growth Rate of Return An accurate value for a security must
include an estimate of the timing and size of the future cash flows. Because money has a
time value, you must estimate the time pattern and growth returns (cash flows) from an
investment.
2- Required Rate of Return

Uncertainty of Returns (Cash Flows)Recall from Chapter 1 that the required return on
an investment is determined by (1) the economy’s real risk-free return, plus (2) the
expected rate of inflation during the holding period, plus (3) a risk premium determined
by the uncertainty of returns. The factor that causes a difference in required rates of
return is the risk premium for investments, which in turn depends on the uncertainty of
the investments ‘returns or cash flows.
We can identify the sources of the uncertainty of returns by the internal characteristics of
assets or by market-determined factors. Earlier, we subdivided the internal characteristics
for a firm into business risk (BR), financial risk (FR), liquidity risk (LR), exchange rate
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risk (ERR), and country risk (CR).The market-determined risk measures are the
systematic risk of the asset (its beta), or a set of multiple risk factors.
3- Investment Decision Process: A Comparison of Estimated Values and Market

Prices
To ensure that you receive your required return on an investment, you must estimate the
investment’s intrinsic value using your required return and then compare this value to the
prevailing market price. If the market price exceeds your estimated value, you should not
buy the investment.
In contrast, if the intrinsic value of the investment exceeds the market price, you should
buy the investment. For example, you read about a firm that produces athletic shoes and
its stock are listed on the TSX. Using one of the valuation models we will discuss, you
estimate the intrinsic stock value is $20 per share. After estimating this value, you look
on the web and see that the stock is currently selling for $15.You would want to buy this
stock. In contrast, if the current market price was $25 per share, you would not want to
buy because, based upon your valuation, the stock is overvalued.
The theory of value provides a common framework for the valuation of all investments.
Different applications of this theory generate different estimated values for various
investments because of the different payment streams and security characteristics. A
bond’s interest and principal payments differ substantially from the expected dividends
and future selling price for a common stock. We use semi-annual compounding because
it is consistent with the interest payments and is used in practice. Method to bonds,
preferred stock, and common stock. This presentation demonstrates that the same basic
model is useful across a range of investments. Subsequently, because of the difficulty in
estimating the value of common stock, we consider two general approaches and
numerous techniques for the valuation of stock.
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VALUATION OF INVESTMENTS
VALUATION OF ASSETS IN GENERAL
The following applies to any financial asset:

V = Current value of the asset
Ct = Expected future cash flow in period (t)
k = Investor’s required rate of return
Note: When analysing various assets (e.g., bonds, stocks), the formula below is simply
modified to fit the particular kind of asset being evaluated.
Example:
Calculate the value of the assets if the annual cash flow is Rs 2000 per year for 7 years if
discount rate is 18 % .
Vo = 2000 × PVIF 18 %, 7
=2000 ×3.812 =7624
(A) VALUATION OF BONDS

Bond valuation is relatively easy because the size and time pattern of cash flows from the
bond over its life are known. A bond typically promises
1. Interest payments every six months equal to one-half the coupon rate times the face
value of the bond
2. The payment of the principal on the bond’s maturity date
The fundamental principle of bond valuation is that the bond's value is equal to the
present value of its expected (future) cash flows. The valuation process involves the
following three steps:
1. Estimate the expected cash flows.
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2. Determine the appropriate interest rate or interest rates that should be used to discount
the cash flows.
3. Calculate the present value of the expected cash flows found in step one by using the
interest rate or interest rates determined in step two.
Determining Appropriate Interest Rates
The minimum interest rate that an investor should accept is the yield for a risk-free bond
(a Treasury bond for a U.S. investor). The Treasury security that is most often used is the
on-the-run issue because it reflects the latest yields and is the most liquid.
For non-Treasury bonds, such as corporate bonds, the rate or yield that would be required
would be the on-the-run government security rate plus a premium that accounts for the
additional risks that come with non-Treasury bonds. As for the maturity, an investor
could just use the final maturity date of the issue compared to the Treasury security.
However, because each cash flow is unique in its timing, it would be better to use the
maturity that matches each of the individual cash flows.
Computing a Bond's Value

First, we need to find the present value (PV) of the bond's future cash flows. The present
value is the amount that would have to be invested today to generate that future cash
flow. PV is dependent on the timing of the cash flow and the interest rate used to
calculate the present value. To figure out the value, the PV of each individual cash flow
must be found. Then, just add the figures together to determine the bond's price.
PV at time T = expected cash flows in period T / (1 + I) to the T power
After you calculate the expected cash flows, you will need to add the individual cash
flows:
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Value = present value @ T1 + present value @ T2 + present value @Tn
Example: The Value of a Bond

Bond GHJ matures in five years with a coupon rate of 7% and a maturity value of $1,000.
For simplicity's sake, let's assume that the bond pays annually and the discount rate is
5%.
The cash flow for each of the years is as follows:

Year One = $70
Year Two = $70
Year Three = $70
Year Four = $70
Year Five = $1,070
Thus, the PV of the cash flows is as follows:
Year One = $70 / (1.05) to the 1st power = $66.67

Year Two = $70 / (1.05) to the 2nd power = $ 63.49
Year Three = $70 / (1.05) to the 3rd power = $ 60.47
Year Four = $70 / (1.05) to the 4th power = $ 57.59
Year Five = $1,070 / (1.05) to the 5th power = $ 838.37
Now to find the value of the bond:
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Value = $66.67 + $63.49 + $60.47 + $57.59 + $838.37

Value = $1,086.59
How Does the Value of a Bond Change?
As rates increase or decrease, the discount rate that is used also changes. Let's change the
discount rate in the above example to 10% to see how it affects the bond's value.
Example: The Value of a Bond when Discount Rates Change

PV of the cash flows is:
Year One = $70 / (1.10) to the 1st power = $ 63.63
Year Four = $70 / (1.10) to the 4th power = $ 47.81
Year Five = $1,070 / (1.10) to the 5th power = $ 664.60
Value = 63.63 + 57.85 + 52.63 + 47.81 + 664.60 = $ 886.52

1.As we can see from the above examples, an important property of PV is that for a given
discount rate, the older a cash flow value is, the lower its present value.
2.We can also compute the change in value from an increase in the discount rate used in
our example. The change = $1,086.59 - $886.52 = $200.07.
3.Another property of PV is that the higher the discount rate, the lower the value of a
bond; the lower the discount rate, the higher the value of the bond.
If the discount rate is higher than the coupon rate the PV will be less than par. If the
discount rate is lower than the coupon rate, the PV will be higher than par value.
How Does a Bond's Price Change as it Approaches its Maturity Date?

As a bond moves closer to its maturity date, its price will move closer to par. There are
three possible scenarios:
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1.If a bond is at a premium, the price will decline over time toward its par value.
2. If a bond is at a discount, the price will increase over time toward its par value.
3. If a bond is at par, its price will remain the same.
Let's use our original example of the 7% bond, but now let's assume that a year has
passed and the discount rate remains the same at 5%.
Example: Price Changes Over Time

Let's compute the new value to see how the price moves closer to par. You should also be
able to see how the amount by which the bond price changes is attributed to it being
closer to its maturity date.
PV of the cash flows is:

Year One = $70 / (1.05) to the 1st power = $66.67
Year Four = $1,070 / (1.05) to the 4th power = $880.29
Value = $66.67 + $63.49 + $60.47 + $880.29 = $1,070.92
As the price of the bond decreases, it moves closer to its par value. The amount of change
attributed to the year's difference is $15.67.
An individual can also decompose the change that results when a bond approaches its
maturity date and the discount rate changes. This is accomplished by first taking the net
change in the price that reflects the change in maturity, then adding it to the change in the
discount rate. The two figures should equal the overall change in the bond's price.
Computing the Value of a Zero-coupon Bond

A zero-coupon bond may be the easiest of securities to value because there is only one
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cash flow - the maturity value.
The formula to calculate the value of a zero coupon bond that matures N years from now
is as follows:
Maturity value / (1 + I) to the power of the number of years * 2

Where I is the semi-annual discount rate.
Example: The Value of a Zero-Coupon Bond

For illustration purposes, let's look at a zero coupon with a maturity of three years and a
maturity value of $1,000 discounted at 7%.
I = 0.035 (.07 / 2)
N = 3
Value of a Zero-Coupon Bond
= $1,000 / (1.035) to the 6th power (3*2)

= $1,000 / 1.229255
= $813.50
Arbitrage-free Valuation Approach

Under a traditional approach to valuing a bond, it is typical to view the security as a
single package of cash flows, discounting the entire issue with one discount rate. Under
the arbitrage-free valuation approach, the issue is instead viewed as various zero-coupon
bonds that should be valued individually and added together to determine value. The
reason this is the correct way to value a bond is that it does not allow a risk-free profit to
be generated by "stripping" the security and selling the parts at a higher price than
purchasing the security in the market.As an example, a five-year bond that pays semi-
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annual interest would have 11 separate cash flows and would be valued using the
appropriate yield on the curve that matches its maturity. So the markets implement this
approach by determining the theoretical rate the U.S. Treasury would have to pay on a
zero-coupon treasury for each maturity. The investor then determines the value of all the
different payments using the theoretical rate and adds them together. This zero-coupon
rate is the Treasury spot rate. The value of the bond based on the spot rates is the
arbitrage-free value.
Determining Whether a Bond Is Under or Over Valued

What you need to be able to do is value a bond like we have done before using the more
traditional method of applying one discount rate to the security. The twist here, however,
is that instead of using one rate, you will use whatever rate the spot curve has that
coordinates with the proper maturity. You will then add the values up as you did
previously to get the value of the bond.
You will then be given a market price to compare to the value that you derived from your
work. If the market price is above your figure, then the bond is undervalued and you
should buy the issue. If the market price is below your price, then the bond is overvalued
and you should sell the issue.
How Bond Coupon Rates and Market Rates Affect Bond Price
If a bond's coupon rate is above the yield required by the market, the bond will trade
above its par value or at a premium. This will occur because investors will be willing to
pay a higher price to achieve the additional yield. As investors continue to buy the bond,
the yield will decrease until it reaches market equilibrium. Remember that as yields
decrease, bond prices rise.
If a bond's coupon rate is below the yield required by the market, the bond will trade
below its par value or at a discount. This happens because investors will not buy this
bond at par when other issues are offering higher coupon rates, so yields will have to
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increase, which means the bond price will drop to induce investors to purchase these
bonds. Remember that as yields increase, bond prices fall
(B)VALUATION OF PREFERRED STOCK

Preferred stock owners receive a promise to pay a stated dividend, usually each quarter,
for an infinite period. Preferred stock is perpetuity because it has no maturity. As was
true with a bond, stated payments are made on specified dates although the issuer of this
stock does not have the same legal obligation to pay investors as do issuers of bonds.
Payments are made only after the firm meets its debt obligations. Because this increases
the uncertainty of returns, investors demand a higher return on a firm’s preferred stock
than on its bonds. Although this differential in required return should exist in theory, it
generally does not exist in practice because dividends paid to corporations are typically
tax-exempt. This tax advantage stimulates the demand for preferred stocks by
corporations; and, because of this demand, the yield on preferred stocks has generally
been below that on the highest grade corporate bonds.
Because preferred stock is perpetuity, its value is simply the stated annual dividend
divided by the required return on preferred stock (k p) as follows:
V = DIVIDEND / (k p)
Consider a $100 par value preferred stock that pays a dividend of $8 per year. Because of
the expected inflation, the uncertainty of the dividend payment, and the tax advantage to
you as a corporate investor, assume that your required return on this stock is
9%.Therefore, the value of this preferred stock to you is:- V = $8 / 0.09 = $88.89
As before, if the current market price of the share is $95, you would decide against a
purchase, whereas if it is $80, you would buy. Lastly, given the market price of preferred
stock you can derive its promised yield. Assuming a current market price of $85, the
promised yield would be:-
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Kp = DIVIDEND / V = $8/$85.00 = 0.0941
Preferred stock features:-

Within the vast spectrum of financial instruments, preferred stocks (or preferreds) occupy
a unique place. Because of their characteristics, they straddle the line between stocks and
bonds. Technically, they are equity securities, but they share many characteristics
with debt instruments. Some investment commentators refer to them as hybrid securities.
In this article, we provide a thorough overview of preferred shares and compare them to
some better-known investment vehicles.
Because so much of the commentary about preferred compares them to bonds and other
debt instruments, let's first look at the similarities and differences between preferred and
bonds.
1 Bonds and Preferred: Similarities
1.Interest Rate Sensitivity

Preferred are issued with a fixed par value and pay dividends based on a percentage of
that par at a fixed rate. Just like bonds, which also make fixed payments, the market
value of preferred shares is sensitive to changes in interest rates. If interest rates rise, the
value of the preferred shares would need to fall to offer investors a better rate. If rates
fall, the opposite would hold true. However, the relative move of preferred yields is
usually less dramatic than that of bonds.
2. Call ability
Preferred technically have an unlimited life because they have no fixed maturity date, but
they may be called by the issuer after a certain date. The motivation for the redemption is
generally the same as for bonds; a company calls securities that pay higher rates than
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what the market is currently offering. Also, as is the case with bonds, the redemption
price may be at a premium to par to enhance the prefer red’s initial marketability.
3. Senior Securities
Like bonds, preferred are senior to common stock; however, bonds have more seniority
than preferred. The seniority of preferred applies to both the distribution of corporate
earnings (as dividends) and the liquidation of proceeds in case of bankruptcy. With
preferred, the investor is standing closer to the front of the line for payment than common
shareholders, although not by much.
4. Convertibility
As with convertible bonds, preferred can often be converted into the common stock of the
issuing company. This feature gives investors flexibility, allowing them to lock in the
fixed return from the preferred dividends and, potentially, to participate in the capital
appreciation of the common stock.
5. Ratings
Like bonds, preferred stocks are rated by the major credit rating companies, such as
Standard & Poor's and Moody's. The rating for preferred is generally one or two tiers
below that of the same company's bonds because preferred dividends do not carry the
same guarantees as interest payments from bonds and they are junior to all creditors.
Common and Preferred Stocks: Difference
1. Payments
Preferred have fixed dividends and, although they are never guaranteed, the issuer has a
greater obligation to pay them. Common stock dividends, if they exist at all, are paid after
the company's obligations to all preferred stockholders have been satisfied.
2. Appreciation
This is where preferred lose their lustre for many investors. If, for example, a
pharmaceutical research company discovers an effective cure for the flu, its common
stock will soar, while the preferred in the same company might only increase by a few
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points. The lower volatility of preferred stocks may look attractive, but preferred will not
share in a company's success to the same degree as common stock. (To learn more, read 5
Signs of A Market-Beating Stock.)
3. Voting
Whereas common stock is often called voting equity, preferred stocks usually have
no voting rights.
Types of Preferred Stock

although the possibilities are nearly endless, these are the basic types of preferred stocks:
-Cumulative: Most preferred stock is cumulative, meaning that if the company withholds
part (or all) of the expected dividends, these are considered dividends in arrears and must
be paid before any other dividends. Preferred stock that doesn't carry the cumulative
feature is called straight, or noncumulative, preferred.
-Callable: The majority of preferred shares are redeemable, giving the issuer the right to
redeem the stock at a date and price specified in the prospectus.
-Convertible: The timing for conversion and the conversion price specific to the
individual issue will be laid out in the preferred stock's prospectus.
-Participating: Preferred stock has a fixed dividend rate. If the company issues those
stocks gain the potential to earn more than their stated rate. The exact formula for
participation will be found in the prospectus. Most preferred are non-participating.
-Adjustable: Rate Preferred Stock (ARPS): These relatively recent additions to the
spectrum pay dividends based on several factors stipulated by the company. Dividends
for ARPSs are keyed to yields on U.S. government issues, providing the investor limited
protection against adverse interest rate markets.
Why Preferred?
A company may choose to issue preferred for a couple of reasons:
1. Flexibility of payments: Preferred dividends may be suspended in case of corporate

cash problems.
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2. Easier to market: The majority of preferred stock is bought and held by institutions,
which may make it easier to market at the initial public offering.
Institutions tend to invest in preferred stock because IRS rules allow U.S. corporations
that pay corporate income taxes to exclude 70% of the dividend income they receive from
their taxable income. This is known as the dividend received deduction, and it is the
primary reason why investors in preferred are primarily institutions.
The fact that individuals are not eligible for such favourable tax treatment should not
automatically exclude preferred from consideration. In many cases, the individual tax rate
under the new rules is 15%. That compares favourably with paying taxes at the ordinary
rate on interest received from corporate bonds. However, because the 15% rate is not an
across-the-board fact, investors should seek competent tax advice before diving into
preferred.
Preferred Stock Pros
-Higher fixed-income payments than bonds or common stock

-Lower investment per share compared to bonds
-Priority over common stocks for dividend payments and liquidation proceeds
-Greater liquidity than corporate bonds of similar quality
Preferred Stock Cons
-Call ability
-Lack of specific maturity date makes recovery of invested principal uncertain
-Limited appreciation potential
-Interest rate sensitivity
(C) VALUATION OF DERIVATIVES
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A derivative is a security with a price that is dependent upon or derived from one or more
underlying assets. The derivative itself is a contract between two or more parties based
upon the asset or assets. Its value is determined by fluctuations in the underlying asset.
The most common underlying assets include stocks, bonds, commodities, currencies,
interest and market indexes.
Types of Derivative Securities
Investors in the derivatives market can earn or lose large sums of money.
Many investors use derivative securities as a way to hedge their investment portfolios
against certain risk. A derivative security derives its value from another underlying
financial security. Derivative securities come in several types, including forward, future,
swap and option contracts. Derivatives are considered sophisticated financial securities,
so it is important for investors to understand how they work and the benefits and risks
associated with them.
A. Forward Contracts
A forward contract is an agreement in which a seller promises to deliver a predetermined
quantity of an asset at a certain date and price to a buyer. The price of a forward contract
is determined at the initial trade date although the asset is delivered in the future. Most
forward contracts are private agreements and are not traded on exchanges. For example, a
farmer may enter into a forward contract to lock in the price of wheat if he believes that
price will rise in the future. Unlike future contracts, forward contracts are typically made
by hedgers who desire to reduce price volatility, so the delivery of goods is almost always
made. The risk of default is greater for forward contracts than future contracts.
Futures Contracts
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Similar to a forward contract, a futures contract represents an agreement for a seller to

deliver goods at a specified time for a predetermined price. Unlike a forward contract,
future contracts are standardized, traded on exchanges and created by a clearinghouse
that acts a middleman between the seller and buyer. The benefit of the clearinghouse is
that the risk of default is eliminated. The parties of futures contracts are required to post
margin, which the brokerage firm uses as collateral.
Swap Contracts
A swap is a type of derivative security in which investors swap one set of cash flow for
another set of cash flow. A currency swap is a common type of swap in which parties
enter a contract to exchange streams of cash flow denominated in two currencies. For
example, a company based in the United States may need to acquire Japanese yen and a
Japanese company may need to acquire U.S. dollars. The two parties can enter into a
contract to exchange currency at a predetermined interest rate for a certain amount and on
a specific date. Another common type of swap is an interest rate swap, which is an
agreement where one stream of future interest rate payments is exchanged for another
party’s fixed cash flows.
Option Contracts
Two types of option contracts exist – call options and put options. Investors purchase a
call option to buy a stock at a specified price and date, and a put option allows investors
to sell a stock at specified price and date. Investors of call options realize a profit if the
price of the underlying asset rises from the time the contract is initiated. Put option
investors profit when the price declines. Option investors are not obligated to buy the
underlying asset at the contract’s expiration date. The value of an option is determined by
its exercise date, time remaining until expiration, the volatility and current market price
of the underlying asset and the current interest rate.
Forward Contract Valuation
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A forward contract has no value at the time it is first entered into (i.e., its net present
value is zero). However, as the contract advances in time, it may acquire a positive or
negative value. Therefore, it would be financially much better to mark the contract to
market, i.e., to value it every day during its life. The value of a long forward contract can
be calculated using the following formula:
f = (F0 - K) e -r.T
where:
f is the current value of forward contract
F0 is the forward price agreed upon today, F0= S0. er.T
K is the delivery price for a contract negotiated some time ago
r is the risk-free interest rate applicable to the life of forward contract or a respective
period within
T is the delivery date
S0 is the spot price of underlying asset
In the same token, the value of a short forward contract is given by:
f = (K - F0). e -r.T
For example, suppose a long forward contract on a non-dividend-paying stock (current
stock price= $50) which has currently 3 months left to maturity. If the delivery price is
$47, and the risk-free interest rate is 5%, then the value of this contract can be calculated
in two steps:
First, we find the forward price (i.e. the 3-month forward price):
F0 = 50 x e0.05x3/12
Then, we plug this price along with the above information in the formula of long forward
contract value:
f = ( 50.63 - 47) e-0.05x3/12 = 3.63 x 0.9876 = $ 3.585
Options Pricing
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Options are derivative contracts that give the holder the right, but not the obligation, to
buy or sell the underlying instrument at a specified price on or before a specified future
date. Although the holder (also called the buyer) of the option is not obligated to exercise
the option, the option writer (known as the seller) has an obligation to buy or sell the
underlying instrument if the option is exercised.
Depending on the strategy, option trading can provide a variety of benefits including the
security of limited risk and the advantage of leverage. Options can protect or enhance an
investor's portfolio in rising, falling and neutral markets. Regardless of the reasons for
trading options or the strategy employed, it is important to understand the factors that
determine the value of an option. This tutorial will explore the factors that influence
option pricing, as well as several popular option pricing models that are used to
determine the theoretical value of options.
1. Underlying Price
The most influential factor on an option premium is the current market price of an
underlying asset. In general, as the price of the underlying increases, call prices increase
and put prices decrease. Conversely, as the price of the underlying decreases, call prices
decrease and put prices increase.
If underlying
Call prices will ... Put prices will ...
prices ...
Increase Increase Decrease
Decrease Decrease Increase
2. Expected Volatility
Volatility is the degree to which price moves, regardless of direction. It is a measure of
the speed and magnitude of the underlying's price changes. Historical volatility refers to
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the actual price changes that have been observed over a specified time period. Option
traders can evaluate historical volatility to future. Implied, on the other hand, is a forecast
of future volatility and acts as an indicator of the current market sentiment.
The greater the expected volatility, the higher the option value
3. Strike Price
The strike price determines if the option has any intrinsic value. Remember, intrinsic
value is the difference between the strike price of the option and the current price of the
underlying. The premium typically increases as the option becomes further in-the-money
(where the strike price becomes more favourable in relation to the current underlying
price). The premium generally decreases as the option becomes more out-of-the-money
(when the strike price is less favourable in relation to the underlying).
Premiums increase as options become further in-the-money
4. Time Until Expiration

The longer an option has until expiration, the greater the chance that it will end up in-the-
money, or profitable. As expiration approaches, the option's time value decreases. In
general, an option loses one-third of its time value during the first half of its life and two-
thirds of its value during the second half. The underlying's
Volatility is a factor in time value; if the underlying is highly volatile, one could
reasonably expect a greater degree of price movement before expiration. The opposite
holds true where the underlying typically exhibits low volatility; the time value will be
lower if the underlying price is not expected to move much.
The longer the time until expiration, the higher the option price
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The shorter the time until expiration, the lower the option price
5. Interest Rate and Dividends

Interest rates and dividends also have small, but measurable, effects on option prices. In
general, as interest rates rise, call premiums will increase and put premiums will
decrease. This is because of the costs associated with owning the underlying; the
purchase will incur either interest expense (if the money is borrowed) or lost interest
income (if existing funds are used to purchase the shares). In either case, the buyer will
have interest costs.
If interest
Call prices will ... Put prices will ...
rates ...
Rise Increase Decrease
Fall Decrease Increase
6. Dividends can affect option prices because the underlying stock's price typically drops
by the amount of any cash dividend on the ex-dividend date. As a result, if the
underlying's dividend increases, call prices will decrease and put prices will increase.
Conversely, if the underlying's dividend decreases, call prices will increase and put prices
34
will decrease.
If dividends ... Call prices will ... Put prices will ...
Rise Decrease Increase
Fall Increase Decrease
(D)APPROACHES OF THE VALUATION OF COMMON STOCK

Because of the complexity and importance of valuing common stock, various valuation
techniques have been devised over time. These techniques fall into one of two general
approaches: (1) the discounted cash flow valuation techniques, where the value of the
stock is estimated based upon the present value of some measure of cash flow, including
dividends, operating cash flow, and free cash flow; and (2) the relative valuation
techniques, where the value of a stock is estimated based upon its current price relative to
variables considered to be significant to valuation, such as earnings, cash flow, book
value, or sales.
WHY EQUITY?
-Investor invest in equity because it gives better return than bonds
-Equity stock can be held as protective measure during the inflation.
-Intrinsic value is the value of the stock which is justified by the assets, earning,
dividends, definite prospects and the factor of the management of the issuing company.
Characteristics of Equity
-Infinite Life
-Returns in the form of dividends and price appreciation.
-Variable and uncertain returns.
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The Single Period Model
The value of equity which will be held for a single period (1 year) and will be sold at the
end of the period is given as:
Where:
Po =current market price of the share
D1= is the dividend expected
P1 =is the price of the share expected
Ke=required rate of return.
Example
Mercury India ltd is expected to declare a dividend of Rs 2.50 and reach the price of Rs
35.00 a year. The required rate of return is 13 %. What is price at which the share would
sold ?
Solution
The current price = 2.50÷1.13 +35 ÷1.13
= 2.21 +31.00 =33.21
What happens if the price of the equity share is expected to grow at a rate of “g “percent
annually? If current price P0, becomes P0(1+g) a year hence.
Valuation with Variable growth rate in Dividend

Some firms have a super normal growth rate followed by normal growth rate. In this case
the price of equity is calculated by the following method.
How you will calculate value of equity ?
Example:-
Consider the equity share of Venus Lab ltd.
Do = current dividend per share = Rs 3.00
n = duration of the period of supernormal growth rate = 5 years
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ga = growth rate during the period of supernormal growth = 25%

gn = normal growth rate after supernormal growth period is over 7%.
Ke = investor’s required rate of return = 14 %
Stock Valuation Approaches and Specific Techniques
1. RELATIVE VALUATION TECHNIQUES:-
• Price/Earnings Ratio (P/E)

• Price/Cash Flow Ratio (P/CF)
• Price/Book Value Ratio (P/BV)
• Price/Sales Ratio (P/S)
2. DISCOUNTED CASH FLOW TECHNIQUES:-
• Present Value of Dividends (DDM)

• Present Value of Operating Free Cash Flow
• Present Value of Free Cash Flow to Equity Approaches to Equity Valuation
Both of these approaches and all of these valuation techniques have several common
factors. First, they are significantly affected by the investor’s required return on the stock
because this rate becomes, or is a major component of, the discount rate. Second, all
valuation approaches are affected by the growth rate estimate used in the valuation
technique—for example, dividends, earnings, cash flow, or sales. Both of these critical
variables must be estimated and as a result, different analysts using the same valuation
techniques will derive different estimates of value for a stock because they have different
estimates for these critical variable inputs.
EQUITY VALUATION MODELS
Three major categories of equity valuation models are as follows:
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1. Present value models (discounted cash flow models).

These models estimate the intrinsic value of a security as the present value of the future
benefits expected to be received from the security. In present value models, benefits are
often defined in terms of cash expected to be distributed to shareholders (dividend
discount models) or in terms of cash flows available to be distributed to shareholders
after meeting capital expenditure and working capital needs (free-cash-flow-to-equity
models).
2.Multiplier models (market multiple models).

These models are based chiefly on share price multiples or enterprise value multiples.
The former model estimates intrinsic value of a common share from a price multiple for
some fundamental variable, such as revenues, earnings, cash flows, or book value.
Examples of the multiples include price to earnings (PIE, share price divided by earnings
per share) and price to sales (PIS, share price divided by sales per share). The
fundamental variable may be stated on a forward basis (e.g., forecasted EPS for the next
year) or a trailing basis (e.g., EPS for the past year), as long as the usage is consistent
across companies being examined. Price multiples are also used to compare relative
values. The use of the ratio of share price to EPS - that is, the PIE multiple-to judge
relative value is an example of this approach to equity valuation.
3. Enterprise value (EV)

Multiples have the form (Enterprise value) / (Value of a fundamental variable). Two
possible choices for the denominator are earnings before interest, taxes, depreciation, and
amortization (EBITDA) and total revenue. Enterprise value, the numerator, is a measure
of a company's total market value from which cash and short term investments have been
subtracted (because an acquirer could use those assets to pay for acquiring the company).
An estimate of common share value can be calculated indirectly from the EV multiple;
the value of liabilities and preferred shares can be subtracted from the EV to arrive at the
value of common equity.
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4. Asset-based valuation models.

These models estimate intrinsic value of a common share from the estimated value of the
assets of a corporation minus the estimated value of its liabilities and preferred shares.
The estimated market value of the assets is often determined by making adjustments to
the book value (carrying value) of assets and liabilities. The theory underlying the asset-
based approach is that the value of a business is equal to the sum of the value of the
business's assets.
The above models are the most popular asset valuation methods, however, each equity
valuation methods has its advantages and disadvantages so it is important to make the
right decision based on the assets features and types.
USES OF EQUITY VALUATION
THE DIVIDEND DISCOUNT MODEL (DDM)

The dividend discount model (DDM) is a method for assessing the present value of
a stock based on the growth rate of dividends.
HOW IT WORKS (EXAMPLE):

The dividend discount model (DDM) seeks to estimate the current value of a
given stock on the basis of the spread between projected dividend growth and the
associated discount rate. The DDM calculates this present value in the following manner:
Present Stock Value = Dividend Share / (RDiscount – RDividend Growth)
In the DDM, a present stock value that is higher than a stock's market value indicates that
the stock is undervalued and that it is a good time to purchase shares.
suppose stock XYZ declares a dividend of two dollars per share and is currently valued at
$125 in the market. Based on the stock's dividend history, a broker determines a dividend
39
growth rate for the stock of five percent per year and a discount rate of seven percent.
The present stock value is calculated as follows:
Present Stock Value = $2.00 per share / (0.07 discount – 0.05 dividend growth)
= $2.00 / 0.02
= $100
With a calculated present value of $100 against a market value of $125, stock XYZ
is overvalued in this instance and represents an opportunity to sell.
WHY IT MATTERS:
The DDM is a tool used by many investors and analysts as a tool to choose stocks. The
greatest disadvantage of the DDM is that it is inapplicable to companies which do not pay
dividends
INFINITE PERIOD DDM AND GROWTH COMPANIES
Recall that the infinite period DDM has the following assumptions:
1. Dividends grow at a constant rate and this rate will continue for an infinite period.
2. The required return (k) is greater than the infinite growth rate (g). If it is not, the model
gives meaningless results because the denominator becomes negative.
What is the effect of these assumptions if you want to use this model to value the stock of
growth companies? Growth companies have the opportunities and abilities to earn returns
on their investments that are consistently above their required rates of return.6 For
example, a firm with a WACC of 12% that is currently earning about 20% on its invested
capital would be considered a growth company. In order to exploit these outstanding
investment opportunities, these growth firms generally retain a high percentage of
earnings for reinvestment, and their earnings will grow faster than those of the typical
firm. You will recall from the discussion in Web Chapter 19 that a firm’s sustainable
growth is a function of its retention rate and its return on equity (ROE).
The earnings growth pattern for these growth companies is inconsistent with the
assumptions of the infinite period DDM.First, the infinite period DDM assumes
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dividends will grow at a constant rate indefinitely. Although it is unlikely that these firms
can maintain such extreme growth rates for an infinite period in an economy where other
firms will compete with them for these high rates of return.
Second, during the periods when these firms experience abnormally high growth rates,
their growth rates probably exceed their required returns. There is no automatic
relationship between growth and risk; a high-growth company is not necessarily a high-
risk company. In fact, a firm growing at a high constant rate would have lower risk (less
uncertainty) than a low growth firm with an unstable earnings pattern.
PRESENT VALUE OF FREE CASH FLOWS TO EQUITY
The third discounted cash flow technique deals with “free” cash flows to equity, which
would be derived after operating free cash flows, have been adjusted for debt payments
(interest and principal). These cash flows precede dividend payments to the common
stockholder. Such cash flows are referred to as free because they are what is left after
providing the funds needed to maintain the firm’s asset base (similar to operating free
cash flow).They are specified as free cash flows to equity because they also adjust for
payments to debt holders and to preferred stockholders.
Vj = E FCFEt / (1+Kj)t
where:
Vj = value of the stock of Firm j

N = number of periods assumed to be infinite
FCFEt = the firm’s free cash flow to equity in Period t.
Again, how an analyst would implement this general model depends upon the firm’s
position in its life cycle. That is, if the firm is expected to experience stable growth,
41
analysts can use the infinite growth model. In contrast, if the firm is expected to
experience a period of temporary supernormal growth, analysts should use the multistage
growth model similar to the process used with dividends and for operating free cash flow.
CHAPTER 6
RELATIVE VALUATION TECHNIQUES
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Contrasting the various discounted cash flow techniques, the relative valuation
techniques implicitly maintain that it is possible to determine the value of a market, an
industry, or a company by comparing it to similar entities on the basis of several relative
ratios that compare its stock price to relevant variables that affect a stock’s value, such as
earnings, cash flow, book value, and sales. Therefore, in this section, we discuss the
following relative valuation ratios: price/earnings (P/E), price/cash flow (P/CF),
price/book value (P/BV), price/sales (P/S), and the entity value/EBITDA (EV/EBITDA).
We begin with the P/E ratio, also referred to as the earnings multiplier model, because it
is the most popular relative valuation ratio. In addition, we will show that the P/E ratio
can be directly related to the DDM in a manner that indicates the variables that affect the
P/E ratio.
(A)EARNINGS MULTIPLIER MODEL

Many investors prefer to estimate common stock value by using an earnings multiplier
model. The reasoning for this approach recalls that the value of any investment is the
present value of future returns and for common stocks; the returns investors are entitled
to receive are the firm’s net earnings. Therefore, one way investors can estimate value is
by determining how many dollars they are willing to pay per dollar of expected earnings
(typically represented by the `estimated earnings during the following 12-month period or
an estimate of “normalized earnings”).For example, if investors are willing to pay 10
times expected or “normal”earnings,a stock they expect to earn $2 per share during the
following year would be valued at $20.The prevailing earnings multiplier, also referred to
as the price/earnings (P/E) ratio, is computed as follows:
EARNINGS MULTIPLIER = PRICE / EARNINGS RATIO
=CURRENT MARKET PRICE/EXPECTED12-MONTH EARNINGS
This indicates the prevailing attitude of investors toward a stock’s value and investors
must decide if they agree with the prevailing P/E ratio (i.e., is the earnings multiplier too
43
high or too low?) based upon how it compares to the P/E ratio for the aggregate market,
for the firm’s industry, and for similar firms and stocks.
To decide whether the P/E ratio is too high or too low, we must consider what influences
the earnings multiplier (P/E ratio) over time. For example, over time the aggregate stock
market P/E ratio, as represented by the S&P/TSX Composite index, has varied from
about 9 to about 26 times earnings.9 The infinite period dividend discount model can be
used to indicate the variables that should determine the value of the P/E ratio as follows:
Pi = D1 / k - q
Dividing both sides of the equation by E1 (expected earnings during the next 12 months),
we get
Pi/E1 = D1/E1 //k-g
Thus, this model implies that the P/E ratio is determined by

1. The expected dividend pay-out ratio (dividends divided by earnings)
2. The estimated required return on the stock (k)
3. The expected growth rate of dividends for the stock (g)
For example, assume a stock has an expected dividend pay-out of 50%, a required return
of 12%, and an expected dividend growth rate of 8%, this would imply that the stock’s
P/E ratio should be:
D/E = 0.50; k=0.12; g=0.08
P/E = 0.50/0.12-0.08 = 12.50
Again, a small difference in either k or g or both will have a large impact on the earnings
multiplier, as shown in the following three examples.
1. Assume a higher k for the stock.
D/E 0.50; k 0.13; g 0.08
P/E = 0.50/0.13-0.08 = 10.00
2. Assume a higher g for the stock and the original k.

44
D/E = 0.50; k = 0.12; g = 0.09

P/E = 0.50/0.12-0.09 = 16.70
3. Assume a fairly optimistic scenario where the k for the stock is only 11% and there is a
higher expected dividend growth rate of 9%.
D/E = 0.50; k = 0.11; g = 0.09
P/E=0.50/0.11-0.09 = 25.00
As before, the spread between k and g is the main determinant of the size of the P/E
ratio. Although the dividend pay-out ratio has an impact, we are generally referring to a
firm’s long-run target pay-out, which is typically rather stable with little effect on year-
to-year changes in the P/E ratio (earnings multiplier).
After estimating the earnings multiple, you would apply it to your estimate of earnings
for the next year (E1) to arrive at an estimated value. In turn, E1 is based on the earnings
for the current year (E0) and your expected growth rate of earnings. Using these two
estimates, you would compute an estimated value of the stock and compare this estimated
value to its market price.
Consider the following estimates for a firm W:

D/E = 0.50; k = 0.12; g = 0.09; Eo = $2.00
Using these estimates, you would compute earnings multiple of:

P/E = 0.50/0.12-0.09 = 0.50/0.03 = 16.70
Given current earnings (E0) of $2.00 and a g of 9%, you would expect E1 to be
$2.18.Therefore, the value (price) of the stock is estimated as:
V=16.7*$2.18 = $36.41
You would then compare this estimated value to the stock’s current market price to
decide whether you should invest in it. This estimate of value is referred to as a two-step
45
process because it requires you to estimate future earnings (E1) and a P/E ratio based on
expectations of k and g.
(B)THE PRICE/CASH FLOW RATIO
The relative price/cash flow valuation ratio has become more popular as concerns over
the propensity of some firms to manipulate earnings per share have grown. Cash flow
values are generally less prone to manipulation. The price to cash flow ratio is computed
as follows:
P/CFj = Pt / CFt+1
where:
P/CFj = the price/cash flow ratio for Firm j
Pt = the price of the stock in Period t
CFt+1 = the expected cash flow per share for Firm j
The variables that affect this ratio are similar to the P/E ratio. Specifically, the main
variables should be: (1) the expected growth rate of the cash flow variable used, and (2)
the risk of the stock as indicated by the uncertainty or variability of the cash flow series
over time. The specific cash flow measure used will vary depending upon the nature of
the company and industry and which cash flow specification (e.g., operating cash flow or
free cash flow) is the best measure of performance for this industry.11 An appropriate
ratio can also be affected by the firm’s capital structure.
(C)THE PRICE/BOOK VALUE RATIO
46
The price/book value (P/BV) ratio has been widely used for many years by analysts in the
banking industry as a measure of relative value. The book value of a bank is typically
considered a good indicator of intrinsic value because most bank assets, such as bonds
and commercial loans, have a value equal to book value. This ratio gained in popularity
and credibility as a relative valuation technique for all types of firms based upon a study
by Fame and French (1992) that indicated a significant inverse relationship between
P/BV ratios and excess rates of return for a cross-section of stocks. The P/BV ratio is
specified as follows:
P / BVj = Pt / BVt+1
where:
P/BVj = the price/book value ratio for Firm j

BVt+1 = the estimated end-of-year book value per share for Firm j
As with other relative valuation ratios, it is important to match the current price with the
book value that is expected to prevail at the end of the year.The difficulty is that this
future book value is not generally available. One can derive an estimate of the end-of-
year book value based on the historical growth rate for all series or use the growth rate
implied by the sustainable growth formula: g = ROE* Retention Rate.
The factors that determine the size of the P/BV ratio are a function of the firm’s ROE
relative to its cost of equity as the ratio would be 1 if they were equal—that is, if the firm
earned its required return on equity. In contrast, if the firm’s ROE is much larger than its
cost of equity, it is a growth company and investors should be willing to pay a premium
price over its book value for the stock.
(D)THE PRICE/SALES RATIO
47
The price/sales (P/S) ratio has a volatile history. It was a favorite of Phillip Fisher (1984),
a well-known money manager in the late 1950s, as well as his son Kenneth Fisher (1984)
and Senchack and Martin (1987). Recently, the P/S ratio has been suggested as useful by
Martin Leibowitz (1997), a widely admired stock and bond portfolio manager. These
advocates consider this ratio meaningful and useful for two reasons. First, they believe
that strong and consistent sales growth is a requirement for a growth company. Although
they note the importance of an above-average profit margin, they contend that the growth
process begins with sales. Second, given all the data in the balance sheet and income
statement, sales information is subject to less manipulation than any other data item. The
specific P/S ratio is:
P/Sj = Pt / St+1
where:
P/Sj = the price to sales ratio for Firm j
St+1= the expected sales per share for Firm j
Again, it is important to match the current stock price with the firm’s expected sales per
share, which may be difficult to derive for a large cross-section of stocks. Two caveats
are relevant to the price to sales ratio. First, this particular relative valuation ratio varies
dramatically by industry. For example, the sales per share for retail firms, such as
Canadian Tire or Shoppers Drug Mart, are typically much higher than sales per share for
computer or microchip firms. The second consideration is the profit margin on sales. The
point is, retail food stores have high sales per share, which will cause a low P/S ratio,
which is considered good until one realizes that these firms have low net profit margins.
Therefore, your relative valuation analysis using the P/S ratio should be between firms in
the same or similar industries.
WHY AND WHEN TO USE THE RELATIVE VALUATION TECHNIQUES
48
While discounted cash flow valuation models can derive intrinsic values that are
substantially above or below prevailing prices depending on how your estimated inputs
have been adjusted. An advantage of the relative valuation techniques is that they provide
information about how the market is currently valuing stock at several levels—that is, the
aggregate market, alternative industries, and individual stocks within industries.
The bad news about relative valuation techniques is that they do not provide guidance on
whether these current valuations are appropriate. This means all valuations at some point
in time could be too high or too low. For example, assume that the market becomes
significantly overvalued. If you were to compare the value for an industry to the much
overvalued market, you might contend based on such a comparison that an industry is
undervalued relative to the market. Unfortunately, your judgment may be wrong because
of the benchmark you are using—that is, you might be comparing a fully valued industry
to a very overvalued market. Alternatively, comparing an undervalued industry to a
grossly undervalued aggregate market, the industry will appear overvalued by
comparison.
Therefore, the relative valuation techniques are appropriate to consider under two
conditions:
1. You have a good set of comparable entities—that is, comparable companies that are
similar in terms of industry, size, and, hopefully, risk.
2. The aggregate market and the company’s industry are not at a valuation extreme—that
is, they are not either seriously undervalued or overvalued.
DISCOUNTED CASH FLOW VALUATION TECHNIQUES
Recall that the basic valuation model says that an asset’s value is the present value of its
expected future cash flows:
Vj = E*CFt / (1+k)t
49
where: Vj = value of Stock j

n = life of the asset
CFt = cash flow in Period t
K = the discount rate that is equal to the investors’ required return for Asset j, which is
determined by the uncertainty (risk) of the asset’s cash flows.
IS THE VALUATION OF BONDS HARDER OR EASIER THAN THE
VALUATION OF EQUITY SECURITIES?
In finance, stocks are often referred to as equity securities, because they make the holder
part owner of the corporation, or provide an equity stake. Bonds, on the other hand, are
lending instruments. The company owes the bondholder a specific sum of money, but the
bonds do not entitle the investor to have a say in how the company is run. Furthermore,
the bondholder will not be paid more than what he is owed if the company does
unexpectedly well. Due to these reasons, bonds are generally easier to value than stocks,
though exceptions exist.
Small Investment Options
-Equity Securities
Equity securities come in various types. The most basic one is common stock, issued by
all companies whose shares change hands in a public exchange, such as the New York
Stock Exchange. Common stock allows the holder to receive a part of the cash
disbursements to shareholders, also known as dividends, approved by the company's
board of directors. Common shareholders also meet once a year and vote on critical
matters that concern the company, including the election of the board of directors. Some
companies issue special share classes, often labeled as "Class A" or Class B" shares, that
have special voting powers. Whereas each common share may entitle the owner to one
vote, a special class share may entitle the holder to two or three votes.
50
-Preferred Stock
Despite their name, preferred shares are more like bonds than shares. The holder of a
preferred share is entitled to a fixed annual payment every year. The main differences
between bonds and preferred shares is that the latter does not expire, while bonds have an
expiration date. Furthermore, unpaid bondholders can sue the company and confiscate its
assets. The board of directors, however, can suspend payments to preferred stockholders
during financial emergencies. The preferred stockholders have no legal recourse in such
situations and must wait until the situation improves. However, until the preferred
stockholders are paid in full, the common shareholders cannot receive a dividend.
-Bonds
A bond promises to reward the owner with a percentage of the bond's original issue value
for a fixed period. The percentage is referred to as the coupon and the original issue value
is known as the par value; bonds also have an expiration date. A bond with par value of
$500 and coupon rate of 7 percent will pay 7 percent of $500, or $35, each year. On the
expiration date, the bondholder will return the bond and receive her original $500 back. A
small subset of bonds are "convertible." The owner of such a bond can surrender the bond
to the issuing company and in its place obtain a specific number of common shares. Each
bond may be exchangeable for three common shares.
WHY AND WHEN TO USE THE DISCOUNTED CASH FLOW VALUATION

APPROACH
Discounted cash flow valuation techniques are obvious choices for valuation because
they are the epitome of how we describe value—the present value of expected cash
flows. The main difference between the techniques is how one specifies cash flow.
The most straightforward measure of cash flow is dividends because these go directly to
the investor, which implies that you should use the cost of equity as the discount rate.
However, this dividend technique is difficult to apply to non-dividend-paying firms, or
firms that pay very limited dividends because they have high return investment
alternatives available. On the other hand, an advantage is that the reduced form of the
51
dividend discount model (DDM) is very useful when discussing valuation for a stable,
mature entity where the assumption of relatively constant growth for the long term is
appropriate.
The second specification of cash flow is the operating free cash flow, which is generally
described as cash flows after direct costs (cost of goods, and S, G & A expenses) and
after allowing for cash flows to support working capital outlays and capital expenditures
required for future growth, but before any payments to capital suppliers. Because we are
dealing with the cash flows available for all capital suppliers, the discount rate employed
is the firm’s weighted average cost of capital (WACC).This is a very useful model when
comparing firms with diverse capital structures because you determine the value of the
total firm (the entity value) and then subtract the value of the firm’s debt obligations to
arrive at a value for the firm’s equity.
A third cash flow measure is free cash flow to equity, which is a measure of cash flows
similar to the operating free cash flow described above, but after payments to debt
holders, which means that these are cash flows available to equity owners. Therefore, the
appropriate discount rate is the firm’s cost of equity.
Beyond being theoretically correct, these models allow a substantial amount of
flexibility in terms of changes in sales and expenses that implies changing growth rates
over time. Once you understand how to compute each measure of cash flow, cash flow
estimates can be made for each year by constructing a pro forma statement for each year
or you can estimate overall growth rates for the various cash flow values.
A shortcoming with these valuation methods is that they are very dependent on the two
significant inputs—(1) the growth rates of cash flows (both the rate of growth and the
duration of growth) and (2) the estimate of the discount rate. As we will show in several
instances, a small change in either of these values can have a significant impact on the
estimated value.
52
ESTIMATING THE INPUTS: THE REQUIRED RETURN AND THE

EXPECTED GROWTH RATE
This section deals with estimating two critical inputs to the valuation process irrespective
of the approach or technique used: the required return (k) and the expected earnings
growth rate and other valuation variables—that is, book value, cash flow, sales, and
dividends.
Required Return (k)

The required return will be the discount rate for most cash flow models and affects all the
relative valuation techniques. There is a difference in the discount rate when using the
present value of operating free cash flow technique because, as noted, it uses the
weighted average cost of capital (WACC). Notably, the cost of equity is a critical input to
estimating the firm’s WACC.
Recall that three factors influence an equity investor’s required return (k):
1. The economy’s real risk-free rate (RRFR)
2. The expected rate of inflation (I)
3. A risk premium (RP)
The Economy’s Real Risk-Free Rate This is the absolute minimum rate that an investor
should require. It depends on the real growth rate of the investor’s home economy
because capital invested should grow at least as fast as the economy. Recall that this rate
can be affected by temporary tightness or ease in the capital markets.
The Expected Rate of Inflation Investors are interested in real returns that will allow
them to increase their rate of consumption. Therefore, if investors expect a given rate of
inflation, they should increase their required nominal risk-free return (NRFR) to reflect
any expected inflation as follows:
NRFR = ((1+RRFR)(1+E(I))) - 1
where: E(I) expected rate of inflation
53
The Risk Premium The risk premium (RP) causes differences in the required returns
among investments that range from government bonds to corporate bonds to common
stocks. The RP also explains the difference in the expected return among securities of the
same type. For example, this is the reason corporate bonds with different ratings of
AAA,AA, or A have different yields, and why different common stocks have widely
varying P/E ratios despite similar growth expectations.
Recall that risk premiums are demanded because of the uncertainty of returns from an
investment. A measure of this uncertainty of returns was the dispersion of expected
returns, and several internal factors influence a firm’s variability of returns, such as its
business risk, financial risk, and liquidity risk. As well, firms with significant foreign
sales and earnings (e.g., Coca-Cola and McDonald’s) have additional risk factors,
including exchange rate risk and country (political) risk.
CHAPTER 7
54
CASE STUDY
SUN PHARMACEUTICAL INDUSTRIES LTD.
Pharmaceutical company
Sun Pharmaceutical Industries Limited is an Indian multinational pharmaceutical
company headquartered in Mumbai, Maharashtra that manufactures and sells
pharmaceutical formulations and active pharmaceutical.
Owners: Dilip Shanghvi
CEO: Dilip Shanghvi
Headquarters: Mumbai
Founder: Dilip Shanghvi
Founded: 1983, Mumbai
Revenue: 276.3 billion INR (2015)
Net income: 54.88 billion INR (2015
CURRENT VALUATION
SUNPHARMA
SUNPHARMA INDUSTRY S&P500 SUNPHARMA
AVG. 5YR AVG.
PRICE/EARNING 58.3 - 21.8 38.2
PRICE/BOOK 3.3 - 3.2 6.9
PRICE/SALES 4.6 - 2.2 7.9
PRICE/CASHFLOW 17 - 14 32.5
DIV YIELD % 0.70% - 2 0.4
PRICE/FAIR PREMIUM - - -

VALUE
Data as of 03/09/2018, *Price/Cash Flow uses 3-year average.
55
FORWARD VALUATION
SUNPHARMA
SUNPHARMA INDUSTRY AVG. S&P 500
FORWARD/PRICE 23.2 - 17.4

EARNINGS
PEG RATIO 0 - -
PE - - -
G PAYBACK(YRS)
Sun's focus on acquiring and building complex drug capabilities enhances its
economic moat.
We see Sun’s low-cost advantage, strong brand recognition in emerging markets, and
proven capability in manufacturing complex products supporting sustainable long-term
profitability. The firm has a narrow economic moat primarily as a result of its low-cost
advantage, which includes low manufacturing and employee costs at its primary
manufacturing base in India and a vertically integrated API division that generates a
cheap source of raw materials, thereby enhancing its cost advantage. The Ranbaxy
acquisition has further strengthened these cost advantages, albeit with regulatory hurdles
that are yet to be overcome.
Most of Sun’s products are off-patent generic drugs that generally have numerous
competitors and low-profitability. However, Sun earns above-average industry
profitability by leveraging its low-cost operations while targeting select complex product
categories with more pricing power. Its focus on geographies where generics can be
marketed and sold under a brand name for a higher price than peers enhances profits
further. rating.
Although Sun has few key products that are likely significant contributors to the
company’s top and bottom line, management’s ability to identify and enter key limited-
56
competition segments on a continuous basis offers compelling opportunities for profitable

growth. For example, Sun is one of the few approved manufacturers for a generic version
of Doxil, an injection for ovarian cancer. In 2014, Doxil proved a highly profitable drug
for Sun, after its only competitor, Johnson & Johnson, had manufacturing issues.
Risk
Sun’s biggest challenge is the risk of changing global regulations on drug manufacturing,
approval processes, product pricing, and taxation. For example, the near-term headwinds
of stricter facility compliance measures by the USFDA led to the issuance of a warning
letter to Sun regarding its Halol facility in December 2015. This facility accounts for
under 10% of the firm’s sales, and the issue is currently being resolved. In light of this
new development, we are moving our uncertainty rating to very high from high, as the
merger integration and compliance issues pile up for the firm..
Global pharmaceuticals companies like Sun are dependent on favorable regulations to
maintain their low-cost advantages. For example, the Indian government's drug pricing
policy of May 2013 placed a cap on the maximum price charged for numerous drugs
deemed as essential medicines for access to the common man. While this particular
change in regulation only had a small impact of approximately INR 0.5 billion on Sun’s
profitability, it had a larger impact on.
Company Profile
With more than INR 275 billion in annual revenue, post the Ranbaxy merger, Sun
Pharmaceuticals is India's largest generic pharmaceutical manufacturer, and the fifth
largest in the world. More than 90% of the firm's top line consists of formulations, with
its geographic reach extending to the US (accounting for 50% in 2015 sales), India
(contributing 24%), other countries (22%), and bulk sales of API (4%).
Chapter 8
57
OBSERVATIONS AND FINDINGS
7.1 Data analysis and discussions
7.1.1 Test of a price-earnings (Whitbeck-Kisor) valuation model
In context of the Indian stock market The model established a negative relationship of the
price earnings ratio with the growth of earnings per share and std. deviation of earnings
per share, but a positive relationship with dividend payout. Poor values of R-squared
reveals that the model is not validated in the Indian stock market not only during 2000-
2015 but also during cross- sectional periods of ten years each during the same time
frame.
7.1.2 Test of Capital Asset Pricing Model (CAPM)
In context of the Indian stock market Except for the years 2002, 2003 and 2006, 2007;
correlation coefficient between systematic risk and return did not show the desired
relationship during the time frame of 1996 – 2015.
7.1.3 To develop a customized valuation model
The result shows that the Indian capital market discounted the three variables the age
(negative relationship), the debt-equity ratio (negative relationship) and beta (strong
positive relationship) explaining the price earnings ratio for the period of 2000-2015
with a very poor Rsquared value of 9.6%.
7.1.4 Test of weak form of efficiency of stock market
(i) Time pattern of security return: The study clearly shows that it is possible to earn
positive return by buying in March and selling in July or November irrespective of the
market condition. This contradicts with the weak form of efficiency, which states the
movement of the market is random and should not follow any pattern. In an efficient
market, no investor can earn an extra return analyzing the historical seasonal pattern of
stock returns.
58
(ii) Correlation test: The result shows a positive constant term and negative coefficients
for all the three dependent variables with a very low R squared value. The research also
concluded that there is a poor relationship exists between current year’s return on BSE
100 index (T) (dependent variable) and the previous three year’s return i.e. T-1, T-2 and
T-3 (independent variables).
7.1.5 Test of semi-strong form of efficiency of stock market
To satisfy the condition for the semi-strong form of efficiency, the abnormal return
should be observed on the date of announcement but not other days. In our experiment,
abnormal positive returns observed on the days from -30 till +30. The study clearly
shows that the Indian capital market fails to satisfy the test of semi-strong form of
efficiency and showed existence of insider trading.
7.1.6 Test of strong form of efficiency of stock market
The Study conducted on the movement of the share price of 30 selected firms around day
0 and Cumulative Abnormal Return (CAR) calculated and plotted. The graph fails to
generate a pattern which can show that the Indian capital market satisfies strong form of
efficiency.
CHAPTER 9
CONCLUSION
59
1. Valuation techniques require an estimate of the investor’s required return on the stock
and the growth rate. As both are estimated, different analysts using the same valuation
techniques will derive different estimates of value for a stock because they have different
estimates for these critical variable inputs.
2. The investment decision process requires the investor to estimate an investment’s

intrinsic value and then compare this value to the prevailing market price. If the market
price exceeds the estimated value, the investment should not be purchased. In contrast, if
the investment’s intrinsic value exceeds the market price, you should buy the investment.
3. A discounted cash flow method is typically used to value both bonds and preferred
stock. The cash flows from the bond are valued as an annuity with a lump sum return of
principal at maturity while preferred stock dividends are valued as perpetuity.
4. Common stock valuation techniques fall into one of two general approaches: (1)
discounted cash flow, where the value of the stock is estimated based upon the present
value of some measure of cash flow; and (2) relative valuation, where the value is
estimated based upon the stock’s current price relative to variables considered to be
significant to valuation, such as earnings, cash flow, book value, or sales.
5. The dividend discount model (DDM) assumes that the value of a share of common
stock is the present value of all future dividends. This model assumes that whenever the
stock is sold, its sale price at that time will be the present value of all future dividends.
For non-dividend paying stocks, the concept is the same, except that some of the early
dividend payments are zero—notably, there is an expectation that at some point the firm
will start paying dividends. Unfortunately, if there is a small change in either g or k, there
will be a significant change in the computed stock’s value.
6. The infinite period DDM cannot be used to value firms that are experiencing
abnormally high rates of growth. These high-growth conditions are temporary, and
60
therefore, after a few years of exceptional growth, the firm’s growth rate is expected to
decline and eventually stabilize at a constant level consistent with the assumptions of the
infinite period DDM.To value a temporary supernormal growth company, you estimate
each year’s growth, and determine the value of the cash flows once there is constant
growth. All of these values are then discounted to the present.
7. To determine value using operating free cash flows (operating cash flows before
interest and after deducting funds needed to for capital expenditures), the firm’s weighted
average cost of capital (WACC) is used as the discount rate. Once the value of the total
firm is calculated, the value of debt is subtracted. The firm’s cost of equity capital (k) is
used to determine value using the free cash flows to equity (cash flows after operating
free cash flows have been adjusted for interest and principal repayment).
8. Relative valuation techniques implicitly maintain that it is possible to determine the

value of a market, an industry, or a company by comparing it to similar entities on the
basis of several relative ratios that compare its stock price to relevant variables that affect
a stock’s value, such as earnings, cash flow, book value, and sales. To properly
implement these techniques, the valuation ratio must be compared over time (e.g., the P/E
ratio) for a company to the comparable ratio for the market, for the stock’s industry, and
to other stocks in the industry to determine how it compares. Secondly you need to
examine the factors that affect each valuation ratio and then compare these factors for the
stock being valued versus the same factors for the market, industry, and other stocks.
9. The basic valuation models and variables are the same around the world but there are
significant differences in the values for specific variables when dealing with foreign
investments. The inputs require an estimate of the NRFR as well as derivation of an
equity risk premium for the investments in each country. Investing globally also means
that there are differences in accounting practices and management philosophies that the
investor must consider.
CHAPTER 10
BIBLIOGRAPHY
61
SECONDARY DATA:-
 Internet source
 Business magazines
-
PUBLICATIONS
 Sourav Mazumder et.al. Asset Valuation: A synthesis of Existing Literature and

New Insights. The Institute of Cost Accountants of India. Volume 42, No. 1, April
2016 pp. 45-52.
 Sourav Mazumder et. al. Efficient Market Hypothesis: A study on Indian Capital
Market. The Institute of Cost Accountants of India.Volume 42, No. IV January
2017 pp. 69-79.
 Sourav Mazumder et.al. Stock Valuation models: A Study of Models in Use and
Development of a Customized Model in India. The ICFAI University, Jharkhand,
Volume 5, Issue 1, May 2017 pp.1-9.
Presentations:
 ‘Asset Valuation: A Synthesis of Existing Literature and New Insights’ presented

in the ‘Globsyn Management Conference 2015’ organized by the ‘Globsyn
Business School’, Kolkata on 18Dec2015 and won the best paper award.
 ‘Stock Valuation models: A Study of Models in Use and Development of a
Customized Model in India’ presented in the National Doctoral Conference
organized by ‘The ICFAI University, Jharkhand’ on 09Mar2017 and own the best
paper award.
62
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TYBFM VALUATION OF SECURITIES

1.1 INTRODUCTION TO VALUATION OF SECURITIES

1.2 OBJECTIVES OF THE STUDY

The objectives of the research are:

 To study valuation of securities in context to investments.

1.3 SIGNIFICANCE OF THE STUDY

Restriction on capital structure

Rationing of commercial bank credit

Restriction on investment opportunities

Underdeveloped securities market

Uncertainty in supply of funds

Complex bureaucracy and regulatory norms

1.4 LIMITATIONS OF THE STUDY

1.5 SCOPE OF THE STUDY

TYPE OF RESEARCH: Descriptive and random sampling research

4. Mc Kinnon and Shaw (2015) advocate liberalisation of financial market,. They

9. Bajpai (2013) establishes that, the liquidity aspect is an essential constituent of an

Books -The Indian Capital Market at Crossroads

Investment process invariability requires the valuation of securities in which the

Securities market is a component of the wider financial market where securities can be

A securities market is a system of interconnection between all participants (professional

1. To transfer real asset into financial asset,

1. A stock or any other security representing an ownership interest. This may be in a

3. In the context of margin trading, the value of securities in a margin account minus

6. When a business goes bankrupt and has to liquidate, the amount of money remaining

2- Required Rate of Return

3- Investment Decision Process: A Comparison of Estimated Values and Market

VALUATION OF ASSETS IN GENERAL

The following applies to any financial asset:

(A) VALUATION OF BONDS

Computing a Bond's Value

PV at time T = expected cash flows in period T / (1 + I) to the T power

Value = present value @ T1 + present value @ T2 + present value @Tn

Example: The Value of a Bond

The cash flow for each of the years is as follows:

Year Two = $70

Year Three = $70

Year Four = $70

Year Five = $1,070

Thus, the PV of the cash flows is as follows:

Year One = $70 / (1.05) to the 1st power = $66.67

Now to find the value of the bond:

Value = $66.67 + $63.49 + $60.47 + $57.59 + $838.37

How Does the Value of a Bond Change?

Example: The Value of a Bond when Discount Rates Change

Value = 63.63 + 57.85 + 52.63 + 47.81 + 664.60 = $ 886.52

How Does a Bond's Price Change as it Approaches its Maturity Date?

Example: Price Changes Over Time

PV of the cash flows is:

Value = $66.67 + $63.49 + $60.47 + $880.29 = $1,070.92

Computing the Value of a Zero-coupon Bond

cash flow - the maturity value.

Maturity value / (1 + I) to the power of the number of years * 2

Example: The Value of a Zero-Coupon Bond

Value of a Zero-Coupon Bond

= $1,000 / (1.035) to the 6th power (3*2)

Arbitrage-free Valuation Approach

Determining Whether a Bond Is Under or Over Valued

(B)VALUATION OF PREFERRED STOCK

Kp = DIVIDEND / V = $8/$85.00 = 0.0941

Preferred stock features:-

1 Bonds and Preferred: Similarities

1.Interest Rate Sensitivity