What is valuation of securities?

Securities valuation refers to the process of determining the fair market value of securities.

These include;

(1)Valuation of equity, and

(2)Valuation of bond

Importance of Valuation of Securities

Security valuation is important to decide on the portfolio of an investor. All investment decisions are to be made on a scientific analysis of the right price of a share.

Hence, an understanding of the valuation of securities is essential. Investors should buy underpriced shares and sell overpriced shares. Share pricing is thus an important aspect of trading.

Applications of Equity Valuation

Following kind of decisions that need to be made based on the value derived from equity valuation.

(a)Stock Picking

(b)Estimating the Market Sentiment

(c)Listing Of Private Businesses

(d)Mergers and Acquisitions

Process of Conducting Equity Valuation

Equity valuation consists of 4 or 5 broad categories of steps that need to be followed.

(1)Understand the macroeconomic factors and the industry

(2)Make a reasonable forecast of the company’s performance

(3)Select the appropriate valuation mode

(4)Arrive at a valuation figure based on the forecast

(5)Take action based on the arrived valuation.

Valuation Models

Conceptually, four types of valuation models are apparent.

(i) Book value,

(ii) Liquidating value,

(iii) Market value,

(iv) Intrinsic value,

(v) Replacement value as compared to market price

Book Value of Security

Book value of a security is an accounting concept. The book value of an equity share is equal to the net worth of the firm divided by the number of equity shares.

Therefore, Book  value of equity = (Total assets – liabilities) / No. of equity shares

Net worth is equal to equity capital plus free reserves. Free reserve means reserves which are available for distribution as dividend.

Therefore, Book  value of equity = (Equity capital + free reserve) / No. of shares

Liquidating Value (Breakdown Value)

This is also an accounting concept. If the assets are valued at their breakdown value in the market and take net fixed assets plus current assets minus current liabilities as if the company is liquidated, then divide this by the number of shares, the resultant value is the liquidating value per share.

Therefore, Liquidating Value = [(Fixed assets – accumulated depreciation) + Current assets – Current liabilities] / No. of equity shares

Market Value

Market value is the easiest valuation concept to understand. It simply means the value of the company or an asset as denoted by its ongoing market price.

Therefore, market value of equity = Total market value of a company / No. of equity shares

Intrinsic Value

Intrinsic value of a share is the present value of all the future benefits expected to be received from that share.

The future benefits from shares refers to annual dividend and capital gain from selling shares.

Replacement Value

When the company is liquidated and its assets are to be replaced by new ones, their prices being higher, the replacement value of a share will be different from the Breakdown value.

Some analysts take this replacement value to compare with the market price.

Calculation of Intrinsic Value

Method of valuation when-

(i) holding period is one year

(ii)holding period is multiple years

(iii) dividend grow up constantly

(iv) there is a multiple growth rate of dividend

(v) there is a discount rate

(v) there is a multiplier

Intrinsic Value at One Year Holding Period

An investor expects to purchase a share now, hold it for one year and sell it of at the end of the one year. The present value of the share is calculated as follows:

Where, D1 = amount of dividend expected to be received at the end of one year,

S1 = Selling price expected to be realised on sale of the share at the end of one year,

k = Rate of return required by the investors

Example: An investor expects to get Tk. 3.50 as dividend from a share next year and hopes to sell of the share at Tk. 45 after holding it for one year, and if required rate of return is 25%,

Ans:

= Tk. 2.80 + Tk. 36

= Tk. 38.80

The investor would buy this share only if its current market price is lower than this value.

Intrinsic Value at Multiple-Year Holding Period

An investor may hold a share for a certain number of years and sell it off at the end of his holding period. In this case, he would receive annual dividend each year and the sale price of the share at the end of the holding period.

The intrinsic value would be as follows:

Where, D1, D2, D3…Dn = annual dividend to be received each year

Sn = Sale price at the end of the holding period

k = Investors’ required rate of return

n= Holding period in years

Example: An investor expects to get Tk.3.50, Tk.4 and Tk.4.5 as dividend from a share during the next three years and hopes to sell it off at Tk. 75 at the end of the third year, and his required rate of return is 25%.

What is the intrinsic value of the share?

Ans:

= Tk. (2.80 + 2.56 + 2.30 + 38.40)

=Tk. 46.06

The investor would buy this share only if its current market price is lower than Tk.46.06

Intrinsic Value at Constant Growth of Dividend (Gordon’s share valuation model)

In this case it is assumed that dividends will grow at the same rate (g) into the infinite future and that the discount rate (k) is greater than the dividend growth rate (g).

The intrinsic value of a share is calculated as follows:

When n approaches infinity, this formula would be as follows:

Example: A company declared a dividend of Tk. 2.5 per share for the current year. The company has been following a policy of enhancing its dividends by 10% every year and is expected to continue this policy in the future. The required rate of return is 15%.

What is the intrinsic value of each share?

Ans:

= Tk. 55.00

The investor would buy this share only if its current market price is lower than Tk.55.00

Intrinsic Value at Multiple Growth Rate of Dividend

This situation can be represented by a two-stage growth model. The initial extraordinary growth model, where growth rate will be variable from year to year. While the subsequent constant growth, where growth rate will remain constant from year to year.

Intrinsic Value at Multiple Growth Rate of Dividend

The intrinsic value of a share is calculated as follows:

So = V1 + V2

Where, V1 =

And V2 =

Example: A company paid a dividend of TK. 1.75 per share during the current year. It is expected to pay a dividend of TK. 2 per share during the next year. Investors forecast a dividend of TK. 3 and TK. 3.5 per share respectively during the two subsequent years. After that it is expected that annual dividend will grow at 10% per year into an indefinite future. The required rate of return is 20%.

What is the intrinsic value of each share?

Ans:

V1 == TK.5.78

V2 = = Tk. 22.28

The intrinsic value of the share = TK. (5.78+ 22.28)

= TK. 28.06

The investor would buy this share only if its current market price is lower than Tk.28.06

Discount Rate

The discount rate used in the present value models is the investor’s required rate of return.

This has to take into consideration the time value of money as well as the risk of the security in which investment is proposed to be made.

The time value of  money is represented by the risk-free interest rate to take care of the risk to be born by the investor by investing in the particular share.

Thus, discount rate or required rate of return would comprise the risk-free rate plus a risk premium.

The present value models discussed earlier also known as dividend discounted valuation models because they discount the stream of dividends expected to be received from a share in the future.

Multiplier Approach to Share Valuation

The commonly used multiplier approach to share valuation is the price-earning (P/E) ratio.

Therefore, Share price = P/E x EPS

The P/E is the current year value of the respective company of which share is valued.

However, to calculate the value of a share, the historical P/E ratios of the company itself or the P/E ratios of other companies in the same industries can be used.

Share Valuation using Multiple Regression

The broad determinants of share prices such as earnings, growth, risk, and dividend policy may be used to estimate appropriate current share price.

Factors which affect the share price is called independent variables, and the factor which is influenced by the independent factors is called dependent variable.

Here, earnings, growth, risk, and dividend policy are the independent variables, and the share price is the dependent variable.

Therefore, the multiple regression for share pricing =

Y= ß0 + ß1X+ ß2X+ …….. + ßkXk + Ɛ.

Where, Y= share price (dependent variable)

  ß0  = Constant value

ß1, ß2, ß3…..slopes or weights of respective   independent variables

  X1, X2, X3  =  independent variables

Ɛ = error term

The regression equation measures the simultaneous impact of the determining variables on the share price.

Example: The constant value term is 8.2, ß1 is 1.5, ß2 is 0.067, and Ɛ  weight is -0.2.

If there is a share with a growth forecast of 7%, dividend pay out of 40% and standard deviation in growth rate amounting to 12.