Securities Valuation
(Chapter 9)
Dr. Amir Rafique
Approaches to Securities
Valuation
Technical Analysis
Market data
Price trends
Technicians/ Chartists
Fundamental Approach
Fundamental analysis
Fundamental factors
Intrinsic value of a security
Fundamentalists
Theory of Valuation
Theory of Valuation
The value of an asset is the present value of its
expected future returns/ benefits/ cash flows
This requires estimates of:
The stream of expected returns/ cash flows, and
The required rate of return on the investment
Theory of Valuation
Investment Decision Process: A Comparison of
Estimated/ True Values and Market Prices
Calculate the intrinsic value of the investment and
then compare with the prevailing market price
If Estimated Value > Market Price, Buy (Undervalued)
If Estimated Value < Market Price, Don’t Buy (Overvalued)
Valuation of Alternative
Investments
Bond Valuation
Preferred Stock Valuation
Common Stock Valuation
TVM and Bond Valuation
Stock Valuation
TVM and Stock Valuation
Valuation of Preferred Stock
Valuation of Preferred Stock
Owner of preferred stock receives a promise to
pay a stated dividend, for perpetuity
There is more uncertainty of returns than the
bonds
PVA CF Present value factor for an annuity
1
1
(1 i) (1 0)
CF CF
i i
CF
i
Valuation of Common Stock
Valuation of Common Stock
Applying valuation to ordinary shares is more difficult
than applying it to bonds for various reasons:
Size and timing of dividends are less certain
Unlike rate of return, or yield, on bonds, rate of return
on ordinary shares cannot be observed directly
Valuation of Common Stock
Approaches to Valuation
Discounted Cash Flow Relative Valuation
Techniques Techniques
• Present Value of Dividends (DDM) • Price/Earnings Ratio (PE)
•Price/Cash flow ratio (P/CF)
•Price/Book Value Ratio (P/BV)
•Price/Sales Ratio (P/S)
Approaches to the
Valuation of Common Stock
Two approaches have developed
Discounted cash-flow valuation
Present value of some measure of cash flow,
including dividends, operating cash flow, and free
cash flow
Relative valuation technique
Value estimated based on its price relative to
significant variables, such as earnings, cash flow,
book value, or sales
Discounted Cash-Flow
Valuation Techniques
Discounted Cash-Flow
Valuation Techniques
t n
CFt
V j
t 1 (1 k ) t
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 investor’s required rate
of return for asset j, which is determined by the uncertainty
(risk) of the stock’s cash flows (CAPM)
The Dividend Discount Model
(DDM)
Thevalue of a share of common stock is the
present value of all future dividends
D1 D2 D3 D
Vj ...
(1 k ) (1 k ) 2
(1 k ) 3
(1 k )
n
Dt
t 1 (1 k ) t Where:
Vj = value of common stock j
Dt = dividend during time period t
k = required rate of return on stock j
The Dividend Discount Model
(DDM)
Constant Growth Dividend Model
Cash dividends do not remain constant but instead
grow at some average rate g from one period to
next forever
Constant dividend growth is appropriate assumption
for mature companies with history of stable growth
The Dividend Discount Model
(DDM)
Infiniteperiod model assumes a constant
growth rate for estimating future dividends
D 0 (1 g ) D 0 (1 g ) 2 D 0 (1 g ) n
Vj 2
...
(1 k ) (1 k ) (1 k ) n
Where:
Vj = value of stock j
D0 = dividend payment in the current period
g = the constant growth rate of dividends
k = required rate of return on stock j
n = the number of periods, which we assume to be infinite
The Dividend Discount Model
(DDM)
Future dividend steam will grow at a constant rate
for an infinite period
D 0 (1 g ) D 0 (1 g ) 2 D 0 (1 g ) n
Vj 2
...
(1 k ) (1 k ) (1 k ) n
This can be reduced to: D1
Vj
Estimate the required rate of return (k) k g
Estimate the dividend growth rate (g)
The Dividend Discount Model
(DDM)-Assumptions
Assumptions of DDM: D1
Vj
k g
Dividends grow at a constant rate
The constant growth rate will continue for an
infinite period
The required rate of return (k) is greater than the
infinite growth rate (g)
Relative Valuation Techniques
Relative Valuation Techniques
Comparables (comps) or price multiples
Comparison of similar stocks based on relative
ratios
Relative valuation ratios include price/earning;
price/cash flow; price/book value and price/sales
Undervalued securities
Overvalued securities
Estimating the Inputs: k and g
Required Rate of Return (k)
Three factors influence an investor’s required
rate of return:
The economy’s real risk-free rate (RRFR)
The expected rate of inflation (I)
A risk premium (RP)
Capital Asset Pricing Model (CAPM)
Expected Growth Rate
Estimating Growth Based on History
Historical growth rates of sales, earnings, cash
flow, and dividends
Arithmetic or geometric average of annual
percentage changes
Issues