Valuation of Securities

Bond Characteristics

A Bond is described in terms of:

Par value
Coupon rate
Maturity date
Present Value of Bond
C C C M
P= + + . +
(1+r) (1+r)2 (1+r)n (1+r)n
 Bond Pricing (Valuation)

n C M
P = +
t=1 (1+r)t (1+r)n

2n C/2 M
P = +
t=1 (1+r/2)t (1+r/2)2n
 Bond Pricing
A Rs.100 face value bond carries a coupon rate of 12 percent p.a.
payable semi-annually. The bond is redeemable at par after 5 years. If
investors require a return of 10% p.a, what will be the price of the bond?
Example
Compute the price of a bond, consider a 10-year, 12 percent coupon
bond with a par value of 1,000. Let us assume that the required yield
on this bond is 13 percent.
 Coupon Rate, Required Yield, & Price

To sum up, the relationship between the coupon rate,

the required yield, and the price is as follows:
Coupon rate > Required yield Price > Par (Premium bond)

Coupon rate = Required yield Price = Par

Coupon rate < Required yield Price < Par (Discount bond)
 Price-Yield Relationship
Price

Yield

Price changes with time

Value of
Bond Premium Bond: rd = 11%

A
PAR VALUE BOND: rd = 13%
B
Discount Bond: rd = 15%

8 7 6 5 4 3 2 1 0
Bonds: Return & Prices
Current Yield
Yield to Maturity(YTM)
Yield to Call
Current Yield

Current Yield = Annual Interest/Current Market Price

A bond paying Rs 100 per year as interest( coupon rate 10%, Face
Value Rs 1000) and currently selling at Rs 900 would have
Current Yield of 100/900 = 11.11%

Current Yield > Coupon Rate If Bond selling at discount & vice-versa
Yield to Maturity(YTM)

C C C M
P= + + . +
(1+r) (1+r)2 (1+r)n (1+r)n
Yield to Maturity(YTM)

A Bond paying 9% p.a. , Face value Rs 1000, currently trading at Rs

800, maturing in 8 years from now. What is Yield to Maturity(YTM)?
Assume tax rate of 30%.
Yield to Call(YTC)

C C C M*
P= + + . +
(1+r) (1+r)2 (1+r)n* (1+r)n
 VALUATION OF PREFERENCE STOCK
n
P= D
+
M
t=1 (1+rp)t (1+rp)n

Since the stream of dividends is an ordinary annuity, we can apply the

formula for the present value of an ordinary annuity. Hence the value of
the preference stock is:

Po = D x PVIFArp,n + M x PVIFr p,n

To illustrate how to compute the value of a preference stock, consider an
8 year, 10 percent preference stock with a par value of Rs. 1000. The
required return on this preference stock is 9 percent.
VALUATION OF PREFERENCE STOCK

The value of the preference stock is

P = 100 x PVIFA 9%, 8yrs + 1000 x PVIF 9%, 8 yrs

= 100 x 5.535 x 1000 x 0.502

= Rs. 1110.5
 DIVIDEND DISCOUNT MODEL
SINGLE PERIOD VALUATION MODEL
D1 P1
P0 = +
(1+r) (1+r)
MULTI - PERIOD VALUATION MODEL
Dt
P0 =
t=1 (1+r)t
ZERO GROWTH MODEL
D
P0 =
r
CONSTANT GROWTH MODEL
D1
P0 =
r-g
Example
The share of a certain stock paid a dividend of Rs.3.00 last year. The
dividend is expected to grow at a constant rate of 8 percent in the
future. The required rate of return on this stock is considered to be 15
percent.
How much should this stock sell for now?
Assuming that the expected growth rate and required rate of return
remain the same, at what price should the stock sell 3 years hence?
Example
Mammoth Corporation is facing gloomy prospects. The earnings and
dividends are expected to decline at the rate of 10 percent. The
previous dividend was Rs.3.00.
If the current market price is Rs.25.00, what rate of return do
investors expect from the stock of Mammoth Limited?
 TWO - STAGE GROWTH MODEL

1 - 1+g1 n

1+r Pn
P0 = D1 +
r - g1 (1+r)n
WHERE
Pn D1 (1+g1)n-1 (1+g2) 1
=
(1+r)n r - g2 (1+r)n
Example: Two- Stage Growth Model
The current dividend on an equity share of Omega Limited is Rs.8.00
on an earnings per share of Rs. 30.00.
(i) Assume that the dividend per share will grow at the rate of 20
percent per year for the next 5 years. Thereafter, the growth rate is
expected to fall and stabilise at 12 percent.
Investors require a return of 15 percent from Omegas equity shares.
What is the intrinsic value of Omegas equity share?
Solution
Example: Two Stage Growth Model
The current dividend on an equity share of Magnum Limited is
Rs.4.00.
(i) Assume that Magnums dividend will grow at the rate of 18 percent
per year for the next 5 years. Thereafter, the growth rate is expected
to fall and stabilise at 10 percent. Equity investors require a return of
15 percent from Magnums equity shares.
What is the intrinsic value of Magnums equity share?
Solution
Example Two Stage Model
TWO - STAGE GROWTH MODEL : EXAMPLE
EXAMPLE THE CURRENT DIVIDEND ON AN EQUITY SHARE OF
VERTIGO LIMITED IS RS.2.00. VERTIGO IS EXPECTED TO ENJOY AN
ABOVE-NORMAL GROWTH RATE OF 20 PERCENT FOR A PERIOD OF 6
YEARS. THEREAFTER THE GROWTH RATE WILL FALL AND STABILISE
AT 10 PERCENT. EQUITY INVESTORS REQUIRE A RETURN OF 15
PERCENT. WHAT IS THE INTRINSIC VALUE OF THE EQUITY SHARE OF
VERTIGO ?
THE INPUTS REQUIRED FOR APPLYING THE TWO-STAGE MODEL ARE :
g1 = 20 PERCENT
g2 = 10 PERCENT
n = 6 YEARS
r = 15 YEARS
D1 = D0 (1+g1) = RS.2(1.20) = 2.40

PLUGGING THESE INPUTS IN THE TWO-STAGE MODEL, WE GET THE

INTRINSIC VALUE ESTIMATE AS FOLLOWS :

1.20 6
1 -
1.15 2.40 (1.20)5 (1.10) 1
P0 = 2.40 +
.15 - .20 .15 - .10 (1.15)6

1 - 1.291 2.40 (2.488)(1.10)

= 2.40 + [0.497]
-0.05 .05

= 13.968 + 65.289
= RS.79.597
 H Model

ga
gn

H 2H

D0
PO = [(1+gn) + H (ga - gn)]
r - gn
D0 (1+gn) D0 H (ga - gn)
= +
r - gn r - gn
Value based Premium due to
on normal abnormal growth rate
growth rate
 Example : H-model
A company ,currently paying dividend of Rs 1 per share, is
forecasting to have a growth of 25% which would
gradually decline to 15% over a period of 10 years and after
that stabilize forever at 15%. Cost of equity is 18%. Find
the intrinsic value per share.
 Illustration: H Ltd

D0 = 1 ga = 25% H=5
gn = 15% r = 18%

1 (1.15) 1 x 5(.25 - .15)

P0 = +
0.18 - 0.15 0.18 - 0.15

= 38.33 + 16.67 = 55.00

IF E = 2 P/E = 27.5
 EARNINGS MULTIPLIER
APPROACH

P0 = m E1

DETERMINANTS OF m (P / E)
D1
P0 =
r-g
E1 (1 - b)
=
r - ROE x b
(1 - b)
P0 / E1 =
r - ROE x b
 Case Study
MiniCase 1 on Page 200-201 Chapter 7