Chapter 5: Security Valuation

5.1 Overview of Valuation

• Investment Definition: Commitment of funds to obtain returns compensating for:

o Time funds are invested or locked.

o Expected inflation over investment horizon.

o Risk involved.

• Investment Returns Forms:

o Earnings, cash flows, dividends, interest payments, compound interest, capital gains.

• Valuation Importance:

o Determines intrinsic value to assess market price consistency.

o Critical for investment decisions, portfolio selection, pricing in business takeovers,

financing, and dividend policy.

• Principles:

o Valuation principles are uniform across asset types (real or financial).

o Complexity and uncertainty vary by asset class, but core principles remain constant.

5.2 Return Concepts

2.1 Required Rate of Return

• Minimum return expected from an investment.

• Also called Opportunity Cost or Cost of Capital.

• Reflects highest forgone return from similar risk investments.

• Often used interchangeably with expected return.

2.2 Discount Rate

• Rate to calculate present value (PV) of future cash flows.

• Depends on risk-free rate plus risk premium.

• Different cash flows may require different discount rates due to risk variations (inflation, maturity,
default).

• Term structure of interest rates explains varying discount rates (e.g., upward sloping term
structure).

• Equivalent single discount rate can be computed to equate PV of cash flows.

2.3 Internal Rate of Return (IRR)

• The discount rate equating PV of future cash flows to initial investment.

• Interpreted as average annual return assuming reinvestment at IRR.

• Example:

o Investment: ₹20,000.

o Cash flows: ₹3,000 in 1st year, ₹23,000 in 2nd year.

o IRR calculated as 15%.

• Reinvestment effect:

o If reinvested at 10% (less than IRR 15%), actual annual return decreases to 14.67%.

o If reinvested at 15%, return remains 15%.

5.3 Equity Risk Premium

• Definition: Excess return on equity shares over risk-free rate (e.g., government bonds).

• Compensates for higher risk in equity investment.

• Varies by portfolio risk and market conditions.

• Based on risk-reward trade-off.

• Theoretical and estimated from historical data; varies by method and timeframe.

3.1 Explanation

• Equity investors demand premium over risk-free returns due to higher risk.

• Example: Risk-free bond returns 7%, equity expected return 15%, so equity risk premium = 8%.

3.2 Calculation Using CAPM

• Formula: 𝑅𝑥 = 𝑅𝑓 + 𝛽𝑥 (𝑅𝑚 − 𝑅𝑓 )

o 𝑅𝑥 : Expected return on equity.

o 𝑅𝑓 : Risk-free rate.

o 𝛽𝑥 : Beta of stock (systematic risk measure).

o 𝑅𝑚 : Expected market return.

• Equity Risk Premium = 𝑅𝑥 − 𝑅𝑓 = 𝛽𝑥 (𝑅𝑚 − 𝑅𝑓 ).

5.4 Required Return on Equity

• Calculated via Capital Asset Pricing Model (CAPM).

• Considers systematic risk (non-diversifiable).

• Formula:

Required return = Risk-free rate + 𝛽 × Market Risk Premium

• Example:

o Risk-free rate = 5%

o Beta = 1.5

o Market risk premium = 4.5%

o Required return = 5% + 1.5 × 4.5% = 11.75%

5.5 Discount Rate Selection in Relation to Cash Flows

• Cash Flows:

o Used to settle debt, taxes.

o Residual cash flows available to equity shareholders.

• Discount Rates:

o Equity cash flows discounted at required return on equity.

o Cash flows available to all stakeholders discounted at cost of capital.

5.1 Nominal vs Real Cash Flows

• Nominal Cash Flow: Future revenues and expenses without inflation adjustment.

• Real Cash Flow: Adjusted for inflation, reflecting purchasing power changes.

• In low inflation, nominal and real cash flows are similar.

• High inflation causes nominal cash flows to be higher than real.

5.2 Discount Rate for Equity Valuation

• Nominal cash flows require nominal discount rates.

• Real cash flows require real discount rates.

• Equity valuation uses nominal cash flows and nominal discount rates because corporate taxes
are stated nominally.

• After-tax nominal WACC used when cash flows are available to all capital providers.
6. Valuation of Equity Shares

Approaches:

1. Dividend Based Models

2. Earning Based Models

3. Cash Flow Based Models

6.1 Dividend Based Models

• Dividends represent equity rewards.

• Assumptions:

o Dividend paid annually.

o First dividend at year-end.

o Equity shares sold at ex-dividend price at year-end.

• Valuation depends on discounted dividend stream at required rate of return 𝐾𝑒 .

Holding Period Valuations

1. One Year Holding Period:

𝐷1 + 𝑃1
𝑃0 =
1 + 𝐾𝑒

Example:

o Dividend = ₹6

o Expected price = ₹36

o Required return = 20%

6 + 36
𝑃0 = = ₹35
1.20

2. Multiple Holding Periods:

o Dividend growth assumptions:

▪ Zero Growth (No Growth Model):

𝐷
𝑃0 =
𝐾𝑒

▪ Constant Growth (Gordon Growth Model):

𝐷0 (1 + 𝑔)
𝑃0 =
𝐾𝑒 − 𝑔
 ▪ Variable Growth:

▪ Multiple growth rates allowed, but infinite horizon requires one perpetual
growth rate.

▪ Growth phases: Growth, Transition, Maturity.

Multi-Stage Dividend Discount Models

• Two Stage Model:

o Supernormal growth for finite years 𝑔1 .

o Normal growth 𝑔2 thereafter.

o Price formula involves discounting dividends in both growth periods plus price at start of
normal growth.

• Three Stage Model:

o Extraordinary growth, transition, then stable growth.

o Includes H Model: linear decline in growth rate during transition.

6.2 Earning Based Models

• Investors may prefer earnings over dividends due to retained earnings growth.

Models include:

• Gordon’s Model:
𝐸𝑃𝑆(1 − 𝑏)
𝑃0 =
𝐾𝑒 − 𝑏𝑟

where 𝑏 is retention ratio and 𝑟 is return on retained earnings.

• Walter’s Model:

𝐷 (𝐸−𝐷)
𝑃0 = +
𝐾𝑒 𝐾𝑒

• Price Earnings (P/E) Ratio Model:

Value = 𝐸𝑃𝑆 × 𝑃/𝐸 Ratio

o EPS = (Profit after tax – Preference dividend) / Number of equity shares.

o P/E estimated via industry or comparable companies.

6.3 Cash Flow Based Models

• Dividend Discount Model (DDM) ignores reinvestment needs.

• Free Cash Flow models incorporate:

o Long-term capital expenditure

o Working capital requirements

Types:

• Free Cash Flow to Firm (FCFF):

o Discounted at cost of capital 𝐾0 .

o Values entire firm.

• Free Cash Flow to Equity (FCFE):

o Discounted at cost of equity 𝐾𝑒 .

o Values equity specifically.

6.3.1 FCFF Calculation

• Based on Net Income:

𝐹𝐶𝐹𝐹 = 𝑁𝐼 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 × (1 − 𝑡) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝑒𝑥 ± Δ𝑁𝑊𝐶

• Based on EBIT:

𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇 × (1 − 𝑡) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − 𝐶𝑎𝑝𝑒𝑥 ± Δ𝑁𝑊𝐶

• Based on EBITDA:

𝐹𝐶𝐹𝐹 = 𝐸𝐵𝐼𝑇𝐷𝐴 × (1 − 𝑡) + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 × 𝑡 − 𝐶𝑎𝑝𝑒𝑥 ± Δ𝑁𝑊𝐶

• Based on FCFE:

𝐹𝐶𝐹𝐹 = 𝐹𝐶𝐹𝐸 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 × (1 − 𝑡) + 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙𝑃𝑟𝑒𝑝𝑎𝑖𝑑 − 𝑁𝑒𝑤𝐷𝑒𝑏𝑡𝐼𝑠𝑠𝑢𝑒𝑑 + 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

• Based on Cash Flow from Operations:

𝐹𝐶𝐹𝐹 = 𝐶𝐹𝑂 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 × (1 − 𝑡) − 𝐶𝑎𝑝𝑒𝑥

• Change in Non-Cash Net Working Capital (ΔNWC) calculated as:

Δ𝑁𝑊𝐶 = 𝑁𝑊𝐶𝑐𝑢𝑟𝑟𝑒𝑛𝑡 − 𝑁𝑊𝐶𝑝𝑟𝑒𝑣𝑖𝑜𝑢𝑠

Where

𝑁𝑊𝐶 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑎𝑠ℎ − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

 • Intrinsic Value of Firm:

o One stage: PV of stable FCFF.

o Two stage: PV of explicit + PV of stable FCFF.

o Three stage: PV of explicit + transition + stable FCFF.

6.3.2 FCFE Calculation

𝐹𝐶𝐹𝐸 = 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝐶𝑎𝑝𝑒𝑥 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 − Δ𝑁𝑊𝐶 + 𝑁𝑒𝑤 𝐷𝑒𝑏𝑡 − 𝐷𝑒𝑏𝑡 𝑅𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
+ 𝑁𝑒𝑡 𝐼𝑠𝑠𝑢𝑒 𝑜𝑓 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑆ℎ𝑎𝑟𝑒𝑠 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠

• Used to measure intrinsic value of equity shares.

• Can be applied in multistage growth valuation.

6.4 Dividend Discount Model vs Free Cash Flow to Equity Model

• DDM:

o Values stock based on dividends paid.

o Assumes consistent dividend payout ratio.

o May undervalue if dividends are low but company retains cash.

• FCFE Model:

o Values stock based on free cash available after reinvestment needs.

o Generally provides better valuation measure than DDM.

6.5 Enterprise Value (EV)

• Definition: True economic value of a company.

• Calculated as:

𝐸𝑉 = Market Capitalization + Long-term Debt + Minority Interest − Cash and Equivalents

− Non-operating Assets

• Types:

o Total EV: All business activities.

o Operating EV: Excludes non-operating assets.

o Core EV: Excludes non-core assets.

• EV is comprehensive, reflecting both equity and debt.

• Less influenced by capital structure.

EV Multiples

• EV to Sales:

o Useful for firms with negative cash flows or cyclicality.

o Sales less manipulable by accounting.

• EV to EBITDA:

o Proxy for cash flow to debt and equity holders.

o Useful for capital-intensive firms.

o Not affected by depreciation or capital structure changes.

6.6 Valuation of Rights

• After right issue, share price is Ex-Right Price or Theoretical Ex-Right Price (TERP):
𝑃0 × 𝑛 + 𝑆 × 𝑛1
𝑇𝐸𝑅𝑃 =
𝑛 + 𝑛1

Where:

o 𝑛 = existing shares,

o 𝑛1 = new shares,

o 𝑃0 = pre-right issue price,

o 𝑆 = subscription amount per right share.

• Value of a right:
𝑇𝐸𝑅𝑃 − 𝑆
Value of Right =
𝑛
7. Valuation of Preference Shares

• Preference shares pay fixed dividends like debentures.

• Non-redeemable preference shares valued as perpetuities:

Dividend
Value =
Required return on preference shares

• Redeemable preference shares valued as:

𝑛
Dividend Maturity Value
Value = ∑ +
(1+𝑟)𝑡 (1+𝑟)𝑛
𝑡=1

• Example:

o Face value: ₹10,000.

o Dividend rate: 10% → ₹1,000 annually.

o Redeemable after 3 years.

o Required return: 12%.

o Value computed as sum of discounted dividends plus maturity value = ₹9,519.63.

8. Valuation of Debentures and Bonds

8.1 Basics of Bonds

• Par Value: Face value at maturity.

• Coupon Rate: Interest rate; payments can be monthly, quarterly, half-yearly, or annually.

• Maturity Period: Time until bond matures.

• Redemption: Usually bullet repayment at par or premium.

8.2 Bond Valuation Formula

𝑛
𝐼 𝐹
𝑉=∑ +
(1+𝑘𝑑 ) 𝑡 (1+𝑘𝑑 )𝑛
𝑡=1

• 𝑉: Bond value.

• 𝐼: Annual interest.

• 𝐹: Par value.

• 𝑘𝑑 : Yield to maturity or required return.

• 𝑛: Maturity years.
8.3 Bond Price Theorems

• If 𝑘𝑑 = coupon rate → bond sells at par.

• If 𝑘𝑑 > coupon rate → bond sells at discount.

• If 𝑘𝑑 < coupon rate → bond sells at premium.

• Longer maturity → greater price sensitivity to 𝑘𝑑 .

8.4 Yield to Maturity (YTM)

• Rate equating bond’s PV of future cash flows to market price.

8.5 Semi-Annual Interest Bond Valuation

𝐼/2×𝑃𝑉𝐼𝐹𝐴(𝑘𝑑 /2,2𝑛)
𝑉= + 𝐹 × 𝑃𝑉𝐼𝐹(𝑘𝑑 /2,2𝑛)

8.6 Price-Yield Relationship

• Bond price inversely related to yield.

8.7 Bond Price and Time

• Bond price converges to par at maturity.

• Premium bonds decrease in price over time.

• Discount bonds increase in price over time.

8.8 Duration of Bond

• Weighted average time to recover investment (principal + interest).

• Factors affecting duration:

o Maturity: Longer → higher duration.

o Coupon Rate: Higher coupon → lower duration.

o YTM: Higher YTM → lower duration.

• Macaulay Duration:
∑𝑡 × 𝑃𝑉(𝐶𝑡 )
𝐷=
𝑃

• Modified Duration:
𝐷
𝐷∗ =
𝑌𝑇𝑀
1+ 𝑛

• Duration measures interest rate risk.

8.9 Immunization

• Balances price risk and reinvestment risk.

• Achieved if bond duration equals holding period.

• Immunized portfolio insensitive to interest rate changes.

8.10 Yield Curve and Spot Rates

• Spot rate: Yield on zero-coupon bond for specific maturity.

• Yield curve: Relationship between yield and maturity.

• Different shapes: upward sloping, flat, inverted, humped.

• Forward rates: Implied future interest rates derived from spot rates.

• Spot and forward rates used to value fixed income securities.

8.11 Term Structure Theories

• Expectation Theory: Long-term rates forecast future short-term rates.

• Liquidity Preference Theory: Investors demand premium for longer maturities.

• Preferred Habitat Theory: Investors have preferred maturities; supply-demand affects rates.

8.12 Convexity Adjustment

• Duration assumes linear price-yield relation; convexity accounts for curvature.

• Improved price change estimate includes convexity term.

8.13 Convertible Debentures

• Debentures convertible into equity shares.

• Conversion ratio: Number of shares per debenture.

• Conversion price: Price paid per share upon conversion.

• Conversion value = Market price × Conversion ratio.

8.14 Warrants

• Rights to buy shares at fixed price within specified period.

• Detachable, separately traded.

• Exercise requires cash.

• Warrant value:

(Market Price − Exercise Price) × No. of shares per warrant

8.15 Zero Coupon Bonds

• No periodic coupons.

• Issued at discount; redeemed at face value.

• Long maturity, used for long-term planning.

• Risk depends on issuer credit strength.

8.16 Refunding of Bonds

• Issuer redeems bonds early, issues new bonds at lower rates.

• Call feature allows early redemption, often with call premium.

• Evaluated using Net Present Value (NPV).

• New bonds issued before refunding old bonds to ensure liquidity.

8.17 Money Market Instruments

• Short duration, large volume, deregulated rates, high liquidity, safe.

• Types:

o Call/Notice Money: Overnight or short-term interbank lending.

o Treasury Bills (TBs): Short-term government promissory notes issued at discount.

o Commercial Bills: Short-term trade-related bills of exchange.

o Certificate of Deposit (CDs): Negotiable term deposits by banks.

o Commercial Paper (CP): Unsecured promissory notes by corporates for short-term funds.

o Repo and Reverse Repo: Sale and repurchase agreements for short-term funds.

9. Role and Responsibilities of Valuers

9.1 Role

• Valuations required for:

o Mergers, acquisitions, de-mergers, takeovers.

o Slump sale, asset sale, IPR sale.

o Debt/security conversion.

o Capital reduction.

o Strategic financial restructuring.

o Statutory compliances (Income Tax Act, Insolvency Code, RBI, SEBI, Companies Act).
9.2 Responsibilities (Model Code of Conduct)

• Integrity and Fairness: Honesty, accurate information, avoid misrepresentation.

• Professional Competence and Due Care: Maintain knowledge, exercise judgment, due
diligence.

• Independence and Disclosure:

o Avoid conflicts of interest.

o Disclose conflicts.

o No insider trading.

o No success fees.

• Confidentiality: Protect client information.

• Information Management: Maintain records, cooperate with authorities.

• Gifts and Hospitality: No acceptance/offering that affects independence.

• Remuneration: Transparent, reasonable fees.

• Occupation and Restrictions: Avoid overcommitment, maintain professional reputation.

10. Precautions Before Accepting Valuation Assignments

• Valuation is a professional estimate, not precise.

• Quality depends on data collection and understanding the company.

• Valuation is more than financial statements; incorporates narrative factors (scalability, growth
potential).

• Investors must balance numbers and qualitative factors.

• Emotions affect stock prices; valuations should consider market psychology.