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VALUATION OF BONDS

AND STOCKS

 Centre for Financial Management , Bangalore


OUTLINE
• Distinction among valuation concepts
• Bond Valuation
• Bond Yields
• Bond Market
• Preferred Stock Valuation
• Equity Valuation : Dividend Discount Model
• Equity Valuation : PE Ratio Approach
• Earnings-Price Ratio, Expected Return, and Growth
• Stock Market

 Centre for Financial Management , Bangalore


CONCEPTS OF VALUE

• Liquidation Value

• Going Concern Value

• Book Value

• Market Value

• Intrinsic Value

 Centre for Financial Management , Bangalore


VALUE OF A BOND

n
P=Σ C
+
M
t=1 (1+r)t (1+r)n

P = C x PVIFAr,n + M x PVIFr,n

 Centre for Financial Management , Bangalore


ILLUSTRATION
To illustrate how to 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. The cash flows for this bond
are as follows:
• 10 annual coupon payments of Rs. 120
• Rs. 1000 principal repayment 10 years from now
The value of the bond is:
P = 120 x PVIFA13%, 10 yrs + 1,000 x PVIF 13%, 10 yrs
= 120 x 5.426 + 1,000 x 0.295
= 651.1 + 295 = Rs. 946.1

 Centre for Financial Management , Bangalore


VALUE OF A BOND WITH SEMI-ANNUAL
INTEREST

2n
P = Σ C/2
(1+r/2)t
+
M
(1+r/2)2n
t=1

P = C/ 2 x PVIFAr/2,2n + M ( PVIFr2,2n)

 Centre for Financial Management , Bangalore


ILLUSTRATION
As an illustration, consider an 8 year, 12 percent coupon bond with a par
value of Rs. 100 on which interest is payable semi-annually. The
required return on this bond is 14 percent.
Applying Eq.(7.2) the value of the bond is:

16
P=Σ 6
+
100
t=1 (1.07)t (1.07)16

= 6(PVIFA7%,16) + 100 (PVIF7%,16)


= Rs. 6(9.447) + Rs.100 (0.339) = Rs. 90.6

 Centre for Financial Management , Bangalore


PRICE-YIELD RELATIONSHIP

 Centre for Financial Management , Bangalore


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)

 Centre for Financial Management , Bangalore


PRICE - YIELD RELATIONSHIP
PRICE

YEILD

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
YEARS TO MATURITY
BOND PRICE THEOREMS
1. Bond prices & yields move in opposite
directions
2. Bond Prices Are More Sensitive To Yield
Changes The Longer Their Maturities
3. The price sensitivity of bonds to yield
changes increases at a decreasing rate
with maturity
4. High coupon bond prices are less sensitive
to yield changes than low coupon bond
prices
5. With a change in yield of a given number of
basis points, the associated percent gain is
larger than the percent loss.
 Centre for Financial Management , Bangalore
BOND YIELDS
• CURRENT YIELD
ANNUAL INTEREST
PRICE
• YIELD TO MATURITY
C C C M
P = + + …. +
(1+r) (1+r)2 (1+r)n (1+r)n
8 90 1,000
800 =  +
t=1 (1+r)t (1+r)8
AT r = 13% … RHS = 808
AT r = 14% … RHS = 768.1
808 - 800
YTM = 13% + (14% - 13%) = 13.2%
808 - 768.1
C + (M - P) / n
YTM ≃
0.4M + 0.6 P
• YIELD TO CALL
n* C M*
P =  +
t=1 (1+r)t (1+r)n
 Centre for Financial Management , Bangalore
REALISED YIELD TO MATURITY
FUTURE VALUE OF BENEFITS
0 1 2 3 4 5
• INVESTMENT 850
• ANNUAL INTEREST 150 150 150 150 150
• RE-INVESTMENT
PERIOD (IN YEARS) 4 3 2 1 0
• COMPOUND FACTOR
(AT 16 PERCENT) 1.81 1.56 1.35 1.16 1.00
• FUTURE VALUE OF
INTERMEDIATE CASH FLOWS 271.5 234.0 202.5 174.0 150.0
• MATURITY VALUE 1000
• TOTAL FUTURE VALUE = 271.5 + 234.0 + 202.5 + 174.0 + 150.0 + 1000
= 2032
(1+r*)5 = 2032 / 850 = 2.391
r* = 0.19 OR 19 PERCENT
 Centre for Financial Management , Bangalore
ILLUSTRATIVE QUOTATION

An illustrative quotation from the WDM segment of NSE pertaining to


no –repo (NR) trades on 31/12/2014 in 8.40% government securities
(GS) issued by central government (CG) and 9.85% bank bonds (BB)
issued by SBI is given below.

Date Security Security Issue Trade No of Traded Low Price High Last Price YTM
Type Name Name Type Trades Value / Rate Price/ Rate

31-Dec-14 GS CG2024 8.40% NR 2 125 103.57 103.6 103.57 7.86

31-Jul-14 BB SBI16 9.85% NR 1 15 101.446 104.446 104.446 8.96

The retail trade in corporate debt securities is done mostly on the capital
market segment of the National Stock Exchange and the debt segment of
the Bombay Stock Exchange.
VALUATION OF PREFERENCE STOCK
n
P=Σ 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.

 Centre for Financial Management , Bangalore


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

 Centre for Financial Management , Bangalore


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
 Centre for Financial Management , Bangalore
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

 Centre for Financial Management , Bangalore


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
 Centre for Financial Management , Bangalore
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 GROWH
GROWTH RATE RATE
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

 Centre for Financial Management , Bangalore


IMPACT OF GROWTH ON PRICE, RETURNS,
AND P/E RATIO

PRICE DIVIDEND CAPITAL PRICE


D1 YIELD GAINS EARNINGS
PO = YIELD RATIO
r-g (D1 / PO) (P1 - PO) / PO (P / E)

RS. 2.00
LOW GROWTH FIRM PO = = RS.13.33 15.0% 5.0% 4.44
0.20 - 0.05

RS. 2.00
NORMALGROWTH PO = = RS.20.00 10.0% 10.0% 6.67
FIRM 0.20 - 0.10

RS. 2.00
SUPERNORMAL PO = = RS.40.00 5.0% 15.0% 13.33
GROWTH FIRM 0.20 - 0.15

 Centre for Financial Management , Bangalore


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
 Centre for Financial Management , Bangalore
E / P, EXPECTED RETURN, AND GROWTH
1 2
……...
E1 = D1 E2 = D2
= 15 = 15
15
r = 15% P0 = = 100
0.15
INVESTMENT .. RS. 15 PER SHARE IN YEAR 1 … EARNS 15%
2.25
NPV PER SHARE = - 15 + = 0
0.15

RATE OF INCREMENTAL PROJECT'S IMPACT ON SHARE PRICE E1/P0 r


RETURN CASH FLOW NPV IN SHARE PRICE IN YEAR 0,
YEAR 1 IN YEAR 0 P0

0.05 0.75 -10 -8.70 91.30 0.164 0.15


0.10 1.50 -5 -4.35 95.65 0.157 0.15
0.15 2.25 0 0 0 0.15 0.15
0.20 3.00 5 4.35 104.35 0.144 0.15
0.25 3.75 10 8.70 108.70 0.138 0.15

 Centre for Financial Management , Bangalore


IN GENERAL, WE CAN THINK OF THE STOCK PRICE AS THE
CAPITALISED VALUE OF THE EARNINGS UNDER THE ASSUMPTION OF
NO GROWTH PLUS THE PRESENT VALUE OF GROWTH OPPORTUNITIES
(PVGO).

E1
P0 = + PVGO
r

MANIPULATING THIS A BIT, WE GET

E1 PVGO
= r 1 -
P0 P0

FROM THIS EQUATION, IT IS CLEAR THAT :


 EARNINGS-PRICE RATIO IS EQUAL TO R WHEN PVGO IS ZERO.
 EARNINGS-PRICE RATIO IS LESS THAN R WHEN PVGO IS
POSITIVE.
 EARNINGS-PRICE RATIO IS MORE THAN R WHEN PVGO IS
NEGATIVE.

 Centre for Financial Management , Bangalore


STOCK MARKET

 Principal Exchanges

• The National Stock Exchange

• The Bombay Stock Exchange

 Veritable Transformation

• Screen-based Trading

• Electronic Delivery

• Rolling Settlement

 Centre for Financial Management , Bangalore


STOCK MARKET INDICES

• Bombay Stock Exchange Sensitive Index (Sensex)


• Base year 1978-79  100
• 30 shares
• Value-weighted index of the free float

• S & P CNX Nifty


• Base period ; November 3, 1995  1,000
• 50 shares
• Value-weighted index

 Centre for Financial Management , Bangalore


STOCK QUOTATION
SYMBOL SERIES OPEN HIGH LOW CLOSE LAST PREV TOTTRD TOT TIME TOTAL ISIN
CLOSE QTY TRDVAL STAMP TRADE
BAJAJ- EQ 2457 2476.4 2432 2451.8 2446 2452.15 164726 40.9197 2-JAN- 10233 INE9171
AUTO 00 15 01010

ISIN stands for International Securities Identification Number.


SUMMING UP

• The term value is used in different senses. Liquidation


value, going concern value, book value, market value, and
intrinsic value are the most commonly used concepts of
value.
• The intrinsic value of any asset, real or financial, is equal
to the present value of the cash flows expected from it.
Hence, determining the value of an asset requires an
estimate of expected cash flows and an estimate of the
required return.
• The value of a bond is:

n
P = Σ C
(1+r)t
+
M
(1+r)n
t=1
 Centre for Financial Management , Bangalore
SUMMING UP

• A basic property of a bond is that its price varies inversely


with yield.
• The relationship between coupon rate, required yield, and
bond price is as follows:
Coupon rate < Required yield Price < Par (Discount bond)
Coupon rate = Required yield Price = Par
Coupon rate > Required yield Price > Par (Premium bond)

• The current yield on a bond is defined as: Annual interest /


Price.

 Centre for Financial Management , Bangalore


SUMMING UP
• The yield to maturity (YTM) on a bond is the rate of return the
investor earns when he buys the bond and holds it till maturity.
It is the value of r in the bond valuation model. For estimating
YTM readily, the following approximation may be used:
C + (M-P)/n
YTM =
0.4M + 0.6P
• According to the dividend discount model, the value of an
equity share is equal to the present value of dividends expect-
ed from its ownership.
• If the dividend per share remains constant rate, the value of the
share is:
PO = D / r

 Centre for Financial Management , Bangalore


SUMMING UP
• If the dividend per share grows at a constant rate, the value of the
share is:
PO = D1 / (r – g)
• The two key drivers of dividend growth are (a) ploughback ratio
and (b) return on equity.
• The value per share, according to the H model is:
Do (1+gn) DOH(ga-gn)
P = +
r – gn r - gn
• An approach to valuation, practised widely by investment analysts, is
the P/E ratio approach. The value of an equity share, under this
approach, is estimated as follows:
PO = E1 x PO / E1
 Centre for Financial Management , Bangalore
SUMMING UP

• The stock price may be considered as the capitalised value of


of the earnings under the assumption of no growth plus the
present value of growth opportunities.

• The stock market consists of a primary segment and a


secondary segment. The principal bourses are the National
Stock Exchange and the Bombay Stock Exchange,
accounting for the bulk of the trading on the Indian stock
market.

 Centre for Financial Management , Bangalore

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