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Valuation of Bonds and Shares

Valuation of Bonds and Stocks


The concept of risk and return are
determinants of valuation of securities
and physical assets.

Finance manager needs to understand


the variables which influence security
prices, which is logical and necessary
consequence of efficient capital
markets.
Concepts of Value

• Present Value is the most valid and true concept of value.


• Book Value (BV): BV reflects historical cost rather than
value. BV of a debt is the outstanding amount. BV of a share =
Net worth divided by number of shares outstanding.
• Replacement Value: Amount a company would be required
to spend if it were to replace existing asset in the current
condition.
• Liquidation Value: The amount a company could realize if it
sold its assets, after terminating its business.
• Going Concern Value: The value a company could realize if
it sold its business as an operating business.
• Market Value (MV): It is the current value at which an asset
or security is being sold or bought in the market. MV > BV for
profitable & growing concerns. If capital markets are efficient
and in equilibrium MV = Present Value of a Share.
Features of Bonds/Debentures

A bond is a long – term debt instrument/security.


Main features include:
• Face Value/Par Value: A bond (debenture) is generally issued at a
par value of Rs. 100 or Rs. 1000. Interest is paid on FV.

• Interest Rates: Interest rates are known. Interest Rate is tax


deductible. Coupons are detachable certificates of interest.

• Maturity: A bond/debenture is issued for a specified time period.

• Redemption Value: The value that a bondholders gets on maturity.


A bond may be redeemed at par/premium/discount.

• Market Value: The price at which it is bought/ sold is called MV.


Bond Values & Yields
• PV of bonds is the expected cash flow, i.e.
interest payments + repayment of
principal.
• The appropriate capitalization/discount rate
depends upon risk of the bond.
• The risk of government bond < PSU bonds <
bonds issued by companies (debentures).

• A lower discount rate is applied for lower


risk.
(A) Bonds with Maturity
• The principal of a bond with a maturity is payable
after maturity period.
• By comparing the present value of a bond with
current market price, it can be determined
whether the bond is overvalued or undervalued.
• BV = PV of interest + PV of Maturity Value
• Since interest payment are constant over the life
of the bond, the annuity formula to value interest
payments can be used.
Yield to Maturity (YTM): Internal rate of return or the
measure of a bond’s rate of return that considers both interest
income and any capital gain or loss.

YTM of 5 year bond, paying 6% rate of interest on FV Rs. 1000 and currently selling for Rs. 883.40 is 10%
as shown below.

YTM = 10% by trial & error.


A simple measure for YTM is

For the above example, YTM = 80/800 = 10%


Current
• It is the Yield
annual & Yielddivided
interest to Callby bond’s
current value. For the above example, 60/883.40 =
6.8%. The current yield does not account for capital
gain or loss.
• Companies issue bonds with buy back or call
provision. Thus a bond can be called or redeemed
before maturity. The yield on such bonds is
called yield to call, which is similar to yield to
maturity. Suppose the 10%, 10 year, Rs. 1000 bond
is redeemable in 5 years at a call price of Rs. 1050.
The bond is currently selling at Rs. 950.
YTC = 12.7%

YTM= 11.3%
Bond Value and Amortization of
Principal
• A Bond (debenture) may be amortized every year
(the principal is repaid every year rather than at
maturity). The cash flow is uneven.
• CF is cash flow including both interest and
principal.
CF is cash flow including both interest and principal.
B) Pure Discount Bonds

• Also called Deep Discount Bonds/ Zero Interest Bonds / Zero


Coupon Bonds.
• It provides for payment of a lump sum amount at a future date
in exchange for the current price of the bond.
• The difference between the FV of bond and purchase price gives
return or YTM to the investor.

• For example, a company issues a deep – discount bond of Rs.


1000 FV at Rs. 520 today for a period of 5 years.
• Purchase Price = Rs. 500
• Maturity Value = Rs. 1000
• Maturity Period = 5 Years

• YTM = 14% (by trail & error) as shown:


IDBI issued deep – discount bonds of Rs. 5,00,000 FV in 1998 at a price of Rs.
12,750 to be redeemed after 30 years. Implicit interest rate would come out to 13%]

The PV of the amount on maturity is the bond value

(In case, current market yield on similar bonds is 9%).


(C) Perpetual Bonds/Consols

• Bond which has indefinite life and thus no


maturity value.
• The bond is simply discounted value of the
infinite stream of interest flows.
• 10% Rs. 1000 bond will pay Rs. 100 annual
interest in perpetuity.
If Market Yield is 10%, Bo = Rs. 1000
If Market Yield is 20%, Bo = Rs. 500
Market yield and value of Bond are inversely related.
Bond Maturity & Interest Rate Risk: There is an inverse
relationship between interest rate & bond value.

Investors of bonds are exposed to interest rate risks: The


intensity of risk is bigger on bonds with long maturities than with
short maturities as one can sell and re – invest the money in case
of bonds with shorter maturities in case the interest rates are
going up.
Yield Curve and Default Risk
• Yield Curve shows the relationship between
yields to maturity of bonds and debentures to
their maturities. Yield Curve is upward sloping,
implying long – term yields are higher than short
term yields.

• Default Risk and Credit Rating: Risk that a


company will default on its promised obligation
to bondholders is default risk. Govt. bonds entail
lower risk.
Features of Preference Shares
• Claims: Preference shareholders have a claim on assets
and income prior to ordinary shareholders.
• Dividend: Dividend rate is fixed for Preference
shareholders. Dividends paid on preference & equity
shares are not tax deductible.
• Redemption: Both redeemable & irredeemable
preference shares can be issued in India.
• Conversion: Convertible Preference shares can be
issued which are converted to equity shares at a stated
date.
Value of Preference Shares

• Value of Preference Shares =


• Present Value of Dividend + Present Value of
Maturity Value

• Po = Present value of Preference Shares; PDIVt is


preference dividend in period t; Kp = Required Rate
of Return on Preference shares; Pn = Maturity value
of Preference share
Value of Irredeemable Preference Shares:

Present value of irredeemable preference share with Rs. 100 as issued price, dividend
of Rs. 9. Current Yield is 11%.
Yield on Preference Share
• If price of Preference Share = Rs. 81.82 and
Dividend of Rs. 9, what is the current yield/return
to investors?
• 81.82 = 9/ Kp
• Kp = 0.11 or 11%
Valuation of Ordinary Shares
• The valuation of equity shares is relatively more
difficult due to two factors:
2. The rate of payment of dividend is unknown and
payment of dividend is discretionary. Cash flow
is uncertain.
3. Earnings & dividends on equity shares are
expected to grow.

Variable Dividend makes calculations difficult.


Dividend Capitalization:
• Expected cash inflows consists of future dividends
& value of ordinary shares is determined by
capitalizing future dividends stream at
opportunity cost of capital. (The return investors
expect to earn from an investment of equivalent
risk).
Single Period Valuation

• Present value of a share (Po) is determined by PV


of dividend per share at the end of first year, DIV1
+ PV of expected price after 1 year, P1,
Opportunity cost/Expected Rate of return, Ke
If DIV1 = 2, P1 = 21 & Ke = 15%
Po = (2 + 21)/1.05 = Rs. 20

g = (P1 – Po)/ Po
g is expected growth/capital gain.
For the aforesaid example, g = (21 – 20)/20 = 5%
Rearranging, P1 = Po(1 + g)
Multi – Period Valuation

• When the investor in above example, sells shares to


second investor, the new investor obtain stream of
dividends and liquidation price of share in year 2.

• For example, DIV2 = Rs. 2.10


• P2 = 22.05

• Po can be calculated by :
Thus, the general formula for a share is as follows:

If n approaches to infinity
GROWTH DIVIDENDS
• The expected dividends in practice could
increase, decrease or remain same. Due to
retention policies the earnings and dividends
of companies grows over time.

• The retained earnings are reinvested in


business which, if, number of shares does not
change, will increase EPS and expand stream
of DPS.
Normal Growth

• If a totally equity financed firm retains a constant


proportion of earnings (b) and reinvests it at
internal rate return/return on equity (ROE)
dividends with grow (g) at a rate
• g = b × ROE
Normal Growth

Perpetual Growth Model

If Ke > g, DIV1 > 0 and Ke & g remain


constant and perpetual.
Supernormal Growth

In case, a company is experiencing high demand for its products dividends


may grow at supernormal growth rate and subsequently at normal rate.

Share Value = PV of dividends during supernormal growth period


+
PV of dividends during indefinite normal growth period
Earnings Capitalization
• When a firm pay out 100% dividends and does not
retain any earns. b = 0, g = rb = 0
• When a firm’s ROE = Ke as firm lacks real growth
opportunities.
r = Ke
g = rb = Ke b
• Thus, true growth depends on existence of growth
opportunities for reinvestment of retained earnings at
a rate higher capitalization, Ke thereby creating NPV
over and above investment required.
Linkages between Share Price,
Earnings & Dividends
• When investor buy shares there are two
considerations: - dividends and capital gains.
• They may buy growth shares or income shares.

• Growth shares offer greater opportunities for capital


gains dividends yields are low as retention rate is
high.
• Income shares pay higher dividends but lower
prospects for capital gains.
1. For example, if a company follows a b = 40%, r = 20% and g = 8%, EPS1 =
Rs. 6.67, Ke = 12%. Po = Rs. 100

2. For example, if for the same company in case the b = 0, DIV = EPS
Po = Rs. 55.58

= Rs. 55.58

Thus, the difference between Rs. 100 and Rs. 55.58 is the value growth
opportunities. Retention of earnings adds value since it generates cash flow.
Price–Earnings Ratio (P/E Ratio)
• Price of a share divided by EPS = P/E Ratio and
its reciprocal is called earnings – price ratio or
earnings yield (E/P).
• Further, estimation of EPS may be meaningless
because of measurement problem of EPS.
• Earnings may include non – cash items like
depreciation.
• Thus it is difficult to interpret EPS meaningfully
and rely on P/E ratio as a measure of
performance.