Valuation of Shares and Bonds

What is Valuation?
The definition of an Investment is – Investment involves commitment of funds with an
objective to obtain a return that would pay off the investor for the time during which the
funds are invested or locked, for the expected rate of inflation over the investment horizon, and
for the risk involved. Most investments are expected to have future cash flows and a
stated market price (e.g., price of a common stock), and one must estimate a value for the
investment to determine if its current market price is consistent with his estimated
intrinsic value. Investment returns can take many forms, including earnings, cash flows,
dividends, interest payments, interest on interest payments or capital gains (increases in value)
during an investment horizon.
Knowing what an asset is worth and what determines its value is a pre-requisite for making
intelligent investment decisions while choosing investments for a portfolio or in deciding
an appropriate price to pay or receive in a business takeover and in making investment,
financing and dividend choices when running a business. We can make reasonable estimates
of value for most assets, and that the fundamental principles determining the values of all
types of assets whether real or financial, are the same. Some assets may be easier to be
valued than others and for different assets the details of valuation and the uncertainty
associated with their value estimates may vary. However, the core principles of valuation
always remain the same.

Return Concepts
Required Rate of Return
Required rate of return is the minimum rate of return that the investor is expected to receive
while making an investment in an asset over a specified period of time. This is also called
Opportunity Cost or Cost of Capital because it is the highest level of expected return
forgone which is available elsewhere from investment of similar risks. Many times
required rate of return and expected return are used interchangeably.
Discount Rate
Discount Rate is the rate used to calculate present value of future cash flows Discount rate
depends on the risk-free rate and risk premium of an investment. Actually, each cash flow
stream coming from different assets can be discounted at a different discount rate. This is
because of variation in risk premium which may be due to expected inflation rate, different
maturity levels and probability of defaults. This can be explained with the help of term
structure of interest rates. For instance, in upward sloping term structure of interest rates,
interest rates increase with the maturity as longer maturity may mean more inflation risk,
more liquidity risk or more default risk.
Though future cash flows can be discounted at different discount rate, one may use
the same discount rate to get the same present value of a stream of cash flows. When a
single discount rate is applied instead of many discount rates, many individual discount

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rates can be replaced with an equivalent single discount rate which eventually gives the
same present value.
Example: Cash flows and discount rates for each year of cash flows at different maturities have been
given as below:

1st year 2nd year 3rd year 4th year 5th year
Cash flows (Rs.) 100 200 300 400 500
Discount rates 2.0% 3.2% 3.6% 4.8% 5.0%

The present value of this stream of cash flows, by discounting each cash flow with the
respective discount rate, is ` 1,278.99.
The single discount rate that approximately equates the present value of the stream of cash
flows to `1278.99 is 4.4861% (any difference is due to rounding).
Internal Rate of Return
Internal Rate of Return is defined as that discount rate which equates the present value of
future cash flows of a security to its market price. The IRR is viewed as the average annual
rate of return that investors earn over their investment time period assuming that the cash
flows are reinvested at the IRR. This can be explained with the help of an example as
follows:
Example
Suppose you are recommended to invest ` 20,000 now in an asset that offers a cash flow ` 3,000 one year
from now and ` 23,000 two years from now. You want to estimate the IRR of the investment. For this purpose
you must find the discount rate that equates the present value of cash inflows to ` 20,000, the value of the
initial investment.

Time 0 1st year 2nd year

Cash flows (Rs.) (20,000) 3,000 23,000

We solve the following equation for r which denotes IRR and

get 15%. 20000 = 3000/(1+r) + 23000/(1+r)2 => r = 15%

Thus, our IRR is 15%, which implies that we earn on an average 15% on the investment per
annum. Now let’s assume that when we receive ` 3,000, we reinvest it at 10% for one year
and after one year we receive total ` 26,300, ` 3,300 of which is attributable to reinvestment
of ` 3,000. Since we receive total cash `26300 we can estimate the IRR of the investment.
(26300/20000)1/2 – 1 = 0.1467 or 14.67%
Annual return is now at 14.67% if reinvested at 10%, which is actually less than what was
expected to be earned before investment. The reason is that the cash flow was reinvested
at a rate (10%) which is less than our expected IRR (15%).
If we had a chance to reinvest ` 3,000 at 15%, we would receive ` 26,450 at the end of

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2nd year, and the IRR of the investment would be equal to exactly 15% as calculated
below:
(26450/20,000)1/2 – 1 = 0.15 or 15%

Equity Risk Premium

Equity risk premium is the excess return that an investment in equity shares provides over
a risk free rate, such as return from tax free government bonds. This excess return
compensates investors for taking on the higher risk of investing in equity shares of a
company. The size of the premium will change depending upon the level of risk in a
particular portfolio and will also change over time as market risk fluctuates. Generally,
high-risk investments are compensated with a higher premium.
The equity risk premium is based on the idea of the risk-reward trade-off. However,
equity risk premium is a theoretical concept because it is difficult to predict that how a
particular stock or the stock market as a whole will perform in the future. It can only be
estimated by observing stock market and government bond market over a specified period
of time, for instance from 1990 to the present period. Further, estimates may vary
depending on the time frame and method of calculation.
Explanation of Equity Risk Premium
Investment in equity shares of a company is a high risk investment. If an investor is
investing in equity shares of a company, he wants some risk premium over the risk-free
investment avenues such as government bonds. For example, if an investor could earn a
7% return on a Government Bond (which is generally considered as risk free investment),
a company’s share should earn 7% return plus an additional return (the equity risk
premium) in order to attract the investor.
Equity investors try to achieve a balance between risk and return. If a company wants to
pursue investors to put their money into its stock, it must provide a stimulus in the form of
a premium to attract the equity investors. If the stock gives a 15% return, in the example
mentioned in the previous paragraph, the equity risk premium would be 8% (15% - 7% risk
free rate). However, practically, the price of a stock, including the equity risk premium,
moves with the market. Therefore, the investors use the equity risk premium to look at
historical values, risks, and returns on investments.
Calculating the Equity Risk Premium
To calculate the equity risk premium, we can use the Capital Asset Pricing Model
(CAPM), which is usually written:
Rx = Rf + βx (Rm - Rf)
Where:
Rx = expected return on equity investment in "x"(company x)
Rf = risk-free rate of return
βx = beta of "x"
Rm = expected return of market

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Now, if we assume that x is identical to the Market Index, m, then R x = Rm. Beta is a
measure of a stock's systematic risk ; and if x = m, then βx = βm = 1. Whereas Rm -
Rf is known as the Market Risk Premium; Rx - Rf is the risk premium of a particular
stock. If x is an equity investment, then Rx - Rf is the equity risk premium; if x = m,
then the market premium and the equity risk premium are the same.
Therefore, the equity risk premium can be calculated as follows:
Equity Risk Premium = Rx - Rf = βx (Rm - Rf)

Required Return on Equity

If equity risk premium is calculated as indicated above, required rate of return can be
easily calculated with the help of Capital Asset Pricing Model (CAPM). The main insight
of the model is that the investors evaluate the risk of an asset in terms of the asset’s
contribution to the systematic risk (cannot be reduced by portfolio diversification) of their
total portfolio. CAPM model provides a relatively objective procedure for required return
estimation; it has been widely used in valuation.
So, the required return on the share of particular company can be computed as below:
Return on share ‘A’ = Risk free return + β x Market Risk Premium
Example:
Risk free rate 5%,
β 1.5
and, Market risk premium 4.5%
Calculate Required return
on equity.

Valuation of Equity Shares

In order to undertake equity valuations, an analyst can use different approaches, some of
which are classified as follows:
(1) Dividend Based Models
(2) Earning Based Models
(3) Cash Flows Based Model
Dividend Based Models
As we know that dividend is the reward for the provider of equity capital, the same can be
used to value equity shares. Valuation of equity shares based on dividend are based on
the following assumptions:
a. Dividend to be paid annually.

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 b. Payment of first dividend shall occur at the end of first year.
c. Sale of equity shares occur at the end of a year and that to at ex-dividend price.
The value of any asset depends on the discounted value of cash streams expected from the
same asset. Accordingly, the value of equity shares can be determined on the basis of stream of
dividend expected at Required Rate of Return or Opportunity Cost i.e. Ke (Cost of Equity).
Value of equity share can be determined based on holding period as follows:

Valuation Based on Multi Holding Period: In this type of holding following three
types of dividend pattern can be analyzed.
Zero Growth: Also, called as No Growth Model, as dividend amount remains same over
the years infinitely. The value of equity can be found as follows:

Constant Growth: Constant Dividend assumption is quite an unrealistic assumption.

Accordingly, one very common model used is based on Constant Growth in dividend for
infinitely long period. In such situation, the value of equity shares can be found by using
following formula:

It is important to observe that the above formula is based on Gordon Growth Model of
Calculation of Cost of Equity.

Variable Growth in Dividend: Just like no growth in dividend assumption, the constant
growth assumption also appears to be unrealistic. Accordingly, valuation of equity shares
can be done on the basis of variable growth in dividends. It should however be noted that
though we can assume multiple growth rates but one growth rate should be assumed for
infinity, only then we can find value of equity shares.
Although stages of Company’s growth fall into following categories such as Growth,
Transition and Maturity Phase but for Valuation the multiple dividend growth can be
divided into following two categories.
a) Two stage Dividend Discount Model

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 b) Three Stage Dividend Discount Model

Earning Based Models

Above mentioned models are based on Dividends. However, nowadays an investor might
be willing to forego cash dividend in lieu of higher earnings on retained earning ultimately
leading to higher growth in dividend.
Hence, these investors may be interested in determination of value of equity share based on
Earning rather than Dividend. The different models based on earnings are as follows:
(a) Gordon’s Model: This model is based on following broad assumptions:
i. Return on Retained earnings remains the same.
ii. Retention Ratio remains\the
same.
Valuation as per this model shall
be

Where, r= return on equity

b = Retention Ratio

Walter’s Approach: This approach is based on Walter Model discussed at Intermediated

Level in the Financial Management Paper. As per this model, the value of equity share
shall be:

Price Earning Ratio or Multiplier Approach: This is one of the common valuation approaches
followed. Since, Price Earning (PE) Ration is based on the ratio of Share Price and EPS,
with a given PE Ratio and EPS, the share price or value can simply be determined as
follows:
Value = EPS X PE Ratio
Now, the question arises how to estimate the PE Ratio. This ratio can be estimated for a
similar type of company or of industry after making suitable adjustment in light of
specific features pertaining to the company under consideration. It should further be
noted that EPS should be of equity shares.

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Cash Flow Based Models
In the case of Dividend Discounting Valuation model (DDM) the cash flows are dividend
which are to be distributed among equity shareholders. This cash flow does not take into
consideration the cash flows which can be utilised by the business to meet its long-
term capital expenditure requirements and short-term working capital requirement. Hence
dividend discount model does not reflect the true free cash flow available to a firm or the
equity shareholders after adjusting for its capex and working capital requirement.
Free cash flow valuation models discount the cash flows available to a firm and equity
shareholders after meeting its long term and short-term capital requirements. Based on the
perspective from which valuations are done, the free cash flow valuation models are
classified as:
• Free Cash Flow to Firm Model (FCFF)
• Free Cash Flow to Equity Model (FCFE)
In the case of FCFF model, the discounting factor is the cost of capital (Ko) whereas in the
case of FCFE model the cost of equity (Ke) is used as the discounting factor.
Calculation of Free Cash Flow to Firm (FCFF): FCFF can be calculated as follows:
(a) Based on its Net Income:
FCFF= Net Income + Interest expense *(1-tax) + Depreciation -/+ Capital
Expenditure –/+
Change in Non-Cash Net Working Capital
(b) Based on Operating Income or Earnings Before Interest and Tax (EBIT):
FCFF= EBIT *(1 - tax rate) + Depreciation -/+ Capital
Expenditure –/+ Change in Non-Cash Net Working Capital
(c) Based on Earnings before Interest, Tax , Depreciation and Amortisation
(EBITDA):
FCFF = EBITDA* (1-Tax) +Depreciation* (Tax Rate) -/+
Capital Expenditure – /+Change in Non-Cash Net Working
Capital
(d) Based on Free Cash Flow to Equity (FCFE):
FCFF = FCFE + Interest* (1-t) + Principal Prepaid – New Debt Issued +
Preferred Dividend
(e) Based on Cash Flows:
FCFF = Cash Flow from Operations (CFO) + Interest (1-t) -/+ Capital Expenditure

Calculation of Free Cash Flow to Equity (FCFE): Free Cash flow to equity is used
for measuring the intrinsic value of the stock for equity shareholders. The cash that is
available for equity shareholders after meeting all operating expenses, interest, net debt

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obligations and re- investment requirements such as working capital and capital
expenditure. It is computed as:
Free Cash Flow to Equity (FCFE) = Net Income - Capital Expenditures + Depreciation -/+
Change in Non-cash Net Working Capital + New Debt Issued - Debt Repayments + Net
issue of Preference Shares – Preference Share Dividends
FCFE = Net Profit + depreciation - ∆NWC - CAPEX + New Debt - Debt Repayment +
Net issue of Preference Shares – Preference Share Dividends
∆NWC = changes in Net Working Capital.
CAPEX = Addition in fixed assets to sustain the basis.
FCFE can also be used to value share as per Multistage Growth Model approach.

VALUATION OF PREFERENCE SHARES

Preference shares, like debentures, are usually subject to fixed rate of dividend. In case of
non- redeemable preference shares, their valuation is similar to perpetual bonds.
Valuation of Redeemable preference share
The value of redeemable preference share is the present value of all the future expected
dividend payments and the maturity value, discounted at the required return on preference
shares. Therefore, Value of Redeemable Preference Share shall be:

VALUATION OF DEBENTURES AND BONDS

Some Basics of a Bond
(a) Par Value: Value stated on the face of the bond of maturity.
(b) Coupon Rate and Frequency of Payment: A bond carries a
specific interest rate known as the Coupon Rate. The coupon can
be paid monthly, quarterly, half-yearly or annually.
(c) Maturity Period: Total time till maturity.
(d) Redemption: Bullet i.e. one shot repayment of principal at par or premium.
Bond Valuation Model

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Bond Value Theorem –
CAUSE EFFECT
Required rate of return or YTM = coupon Bond sells at par value
rate
Required rate of return or YTM > coupon Bond sells at a discount
rate
Required rate of return or YTM < coupon Bond sells at a premium
rate
Longer the maturity of a bond Greater the bond price change with a given change in
the required rate of return.

Yield to Maturity (YTM)

The YTM is defined as that discount rate (“kd”) at which the present value of future
cash flows from a Bond equals its Market Price.