CHRIST – 5BBAH – FINANCE – SAPM – VALUATION OF SECURITIES – EQUITY SHGARES

VALUATION OF SECURITIES

Introduction – Meaning and Concept of value – Meaning of Valuation – Factors

influencing value and valuation – Meaning of valuation of securities

Meaning of bonds – Features of a bond - Types of bonds – Concept of yield –

Current yield –Yield-to-Maturity – Yield-to-Call – Valuation of bond (bonds with
maturity, Pure discount bond and perpetual bond) - Price-yield relationship

Meaning and features of preference shares - Valuation of preference shares

Meaning of ordinary / equity / common stock – features of equity share -Valuation

of ordinary shares - Methods of equity valuation – Intrinsic valuation Approach –
(Discounted cash flow method: Dividend capitalization model and Earnings
capitalization model) – Relative valuation approach: Multiplier method.

INTRODUCTION TO VALUATION
Introduction – Meaning and Concept of value – Meaning of Valuation – Factors
influencing value and valuation – Meaning of valuation of securities

VALUATION OF ORDINARY SHARES

Meaning of ordinary / equity / common stock – features of equity share -Valuation
of ordinary shares - Methods of equity valuation – Intrinsic valuation Approach –
(Discounted cash flow method: Dividend capitalization model and Earnings
capitalization model) – Relative valuation approach: Multiplier method.

Meaning of ordinary / equity / common stock

Ordinary shares (referred to as common shares in USA) represent the ownership position in a
joint stock company. The holders of ordinary shares called shareholders (or stockholders n
USA), are the legal owners of the company. Ordinary shares are the sources of permanent capital
since they do not have a maturity date. For the capital contributed by purchasing ordinary shares,
the shareholders are entitled for dividends. The amount or rate of dividend is not fixed. The
company’s board of directors decides it. An ordinary is therefore known as a variable income
security. Being the owners of the company, shareholders bear the risk of ownership. They are
entitled to dividends after the income claims of others have been satisfied. Similarly, when the
company is wound up, they can exercise their claims on assets after the claims of other suppliers
of capital have been met.

Features of equity shares

✓ Ownership security
✓ Voting rights

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✓ Right to control the company

✓ Preemptive rights
✓ Residual claim on income and assets of the company
✓ Variable income security
✓ Limited liability
✓ Risky security from investor’s point of view

Valuation of ordinary shares

The security analysis helps the investors with the process of identifying great companies with
high potential. But even the most wonderful business is a poor investment if purchased for too
high price. To invest successfully means we need to buy great companies at attractive prices. In
order to facilitate such purchase, equity valuation becomes an important exercise.

As we know the value of any security is the stream of cash flow expected from it. The cash flows
expected by the investors on a common stock or equity stock can be dividend and capital gain
which are uncertain. At the same time the earnings and dividends are expected to grow so the
valuation of common stock is relatively difficult as compared to the bonds and preferred stock.

And thus, intrinsic value of a equity share is the present value of cash flow stream expected from
it discounted at a required rate of return appropriate for the risk associated with the company. If
the market is reasonably efficient, the market price of the security should over around its intrinsic
value.

If the market price is more than the intrinsic value, then the share is said to be overvalued. If the
market price is less than the intrinsic value, then it is said to be undervalued. The investors are
advised to buy the share if it is undervalued (MV < IV) and sel the share when it is overvalued
(MV > IV).

Methods of equity valuation

✓ Intrinsic valuation Approach
✓ Relative valuation approach

Intrinsic valuation Approach or Discounted cash flow method

Intrinsic Value of equity stock is determined by developing some models namely,
✓ Dividend discount model and
✓ Earnings capitalization model

Dividend capitalization model

The value of an equity share is the present value of its future stream of dividends. In other words,
the value of an equity share is a function of cash flows expected by the investors and the risk
associated with cash inflows. This idea is developed in the form of valuation model as mentioned
as below.

Basic Dividend Capitalization Model

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This model is based on an assumption that the investor buys the share to hold it for some
particular period of time, and then he plans to sell it away. If it is the case the following model
can be developed and used to value the common stock.

One period valuation

If an investor plans to buy an equity share to hold it for one year and then sell it, the value of that
share for him will be the present value of expected dividend at the end of one year plus the
present value of expected sale price at the end of the year.
P0 = [D1 / (1+ke)] + [P1 / (1+ke)]

(OR)

P0 = (D1 + P1) / (1+ke)

Where,
P0 = Value of share
D1 = Expected dividend at the end of 1st year
P1 = Expected price of the share at the end of 1st year
ke = Required rate of return.

Illustration 1
Mr. Vinod plans to buy an equity share, hold it for one year and then sell it. The expected
dividend at the end of year 1 is Rs.7 and expected sale price is Rs.200 after 1st year. Determine
the value of share to the investor assuming the discount rate of 15%

Solution
P0 = [D1/(1+ke)] + [P1/(1+ke)]
= [7/1+0.15) ]+[ 200/(1+0.15)]
= 207/1.15
= 180

Exercise 1
a. An investor intends to buy a share and will hold it for one year. Suppose he expects the
share to pay a dividend of Rs. 20 next year, and would sell the share at an expected price
of Rs. 210 at the end of the year. If the investor’s opportunity cost of capital or the
required rate of return is 15% how much should he pay for the share today?
b. Current market price of a share is Rs. 80, next year’s expected dividend is Rs.4 per share,
expected price of share after one year is Rs. 90, required rate of return is 18%. What
should be the value of share and should it be bought at current market price?

Two period Valuation

If an investor plans to hold the share for two years, and then sell it , the value of share will be
calculated as below.

P0 = [D1 / (1+ke)1] + [D2 / (1+ke)2] + [P2 / (1+ke)2]

Where,

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D2 = Expected dividend at the end of 2nd year

P2 = Expected selling price of share after 2 year.

Illustration 2
An investor intends to buy a share and will hold it for two years. Suppose he expects the share to
pay a dividend of Rs. 7 next year and Rs. 7.50 in the second year end and would sell the share at
an expected price of Rs. 220 at the end of year two. If the investor’s opportunity cost of capital
or the required rate of return is 15% how much should he pay for the share today?

Solution
P0 = [D1/(1+ke)1] + [D2/(1+ke)2] + [P2/(1+ke)2]
= [7/(1+0.15)] + [7.50/(1+0.15)2 ]+ [220/(1+0.15)]
= Rs.178

Exercise 2
a. Current market price of a share is Rs. 60, Expected dividends from the share for next 2 years
are Rs.3 and Rs.3.5, Expected price at the end of 2 year is Rs.80, Investor’s required rate of
return is 16%. What’s the value of the share and should it be bought at Rs.60?

b .You as an investor intend to buy a share and will hold it for two years. Suppose you expect the
share to pay a dividend of Rs. 70 next year and Rs. 75 in the second year end and would sell the
share at an expected price of Rs. 2200 at the end of year two. If your required rate of return is
10%, how much should you pay for the share today?

Multi period or n period valuation

If the investor plans to hold the stock for n years and then sells, the value of the share would be,
P0 = [D1 / (1+ke)1] + [D2 / (1+ke)2] + ….. [Dn / (1+ke)n] +[Pn / (1+ke)]n

OR

P0 =  Dt / (1+ke)t + Pn / ( (1+ke)n

If the expected dividend is the same for all the years, then, the value of share will be

P0 = (D * [ (1/ke) – (1 / (ke * (1+ke)n))]) + [Pn / ( (1+ke)n]

Illustration 3
Mr. Vignesh plans to buy a share for Rs.2800 and sell it after 4 years. Advise him in his decision
of buying the equity share on the basis of following data.
a) Expected dividend 1st yr Rs.100, 2nd yr Rs.150, 3rd yr Rs.200 4th yr Rs.250
b) Expected selling price at the end of 4th year Rs.4020
c) Required rate of return is 10%.

Solution

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P0 = [D1/(1+ke)1] + [D2/(1+ke)2] + …..+ [Dn/(1+ke)n] + [Pn/(1+ke)n]

= [100/(1+0.10)] +[150/(1+0.10)2] +[ 200/(1+0.10)3] + [250/(1+0.10)4]+ [4020/(1+0.10)4]
= 90.91 +124.05 + 150.20 + 170.75 + 2746
= 3282
Mr. Vignesh can buy the share. Since intrinsic value (Rs.3282) is less than the market value
(Rs.2800).

Exercise 3
Mr. Vijesh plans to buy a share for Rs.280 and sell it after 4 years. Advise him in his decision of
buying the equity share on the basis of following data.
1. Expected dividend 1st yr Rs.10, 2nd yr Rs.15, 3rd yr Rs.20 4th yr Rs. 25
2. Expected selling price at the end of 4th year Rs.420
3. Required rate of return is 12%.

Illustration 4
Mr. A expects that he will receive a dividend of Rs. 50 per year from the equity share of a
company for the next four years and he can sell the share at the end of fourth year for Rs. 250.
Calculate the intrinsic value of the share if his required rate of return is 10%.

Solution
Po = D * [ (1/ke) – (1 / (ke * (1+ke)n))] + [Pn / ( (1+ke)n]
= [50 * [(1 / 0.1) – (1 / (0.10 * (1+0.10)^4))] + (250 / 1+0.10)^4)
= [50 * (10 – 6.830)] + (250/1.4641)
= (50 * 3.17) + 170.75
= 158.5+170.75 = Rs.329.25

Exercise 4
Mr. B, an investor expects that he will receive a dividend of Rs. 30 per year from the equity
share of a company for the next six years and he can sell the share at the end of sixth year for Rs.
300. Calculate the intrinsic value of the share if his required rate of return is 10%.

Perpetual Dividend valuation models

This model is based on the assumption that equity shares are purchased by investors not to sell in
near future but for holding it for a very long period or infinity. So here, the value of the share is
the capitalized value of an infinite stream of future dividends.

No Growth or Zero Growth Model

If the firm’s dividends remain constant over the period of time, the value of share shall be simply
the capitalization of perpetual stream of future constant dividends.
P0 = D / ke

Illustration 5
You are considering an investment in an equity share which is currently selling in the market for
Rs. 1200, which is expected to give a dividend of Rs. 140 for every year. What will be the value
of the share if your required rate of return is 10%? And What is your decision on buying the
share?

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Solution
P0 = D / ke
= Rs.140 / 0.10
= Rs.1400

Exercise 5
You are approached by your friend who is considering an investment in an equity share which is
currently selling in the market for Rs. 1500, which is expected to give a dividend of Rs.140 for
every year. What will be your advice to your friend if his required rate of return is 15%

Constant Growth Model

This perpetual growth model can be used only when the dividend of a firm is expected to grow at
a constant rate to infinity i.e., forever. The value of such share can be calculated as follows.
P0 = D1/( ke-g) (Or) [D0*(1+g)] / (ke-g)
Where,
D1 = Dividend after 1 year.
D0 = Dividend at the beginning. (or) Current dividend
ke = Required rate of return
g = Expected growth in dividend (%)

Illustration 6
Calculate the intrinsic value of an equity share which is expected to pay a dividend of Rs. 6 at the
end of the year with the annual growth rate of 9% and the required rate of return of the investor
is 15%.
Solution
P0 = D1/(ke-g)
= 6/(0.15-0.09)
= 6/0.06
= Rs.100.

Exercise 6
You are approached by your friend who is considering an investment in an equity share which is
currently selling in the market for Rs. 1100, which is expected to pay a dividend of Rs.60 with
the constant growth rate of 10%. What will be your advice to your friend if his required rate of
return is 15% in buying this share?

A Company paid a dividend of Rs. 3.70 in the previous year. The dividends in the future are
expected to grow perpetually at a rate of 8 per cent. Find out the share’s price today if the market
capitalizes dividend at 12 per cent.

Given last year’s dividend = Rs. 3 per share, expected growth rate 10% p.a., investor’s required
rate 16%. What should be the value of share to the investor? If current market price is Rs.52,
should it be bought?

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The risk free return is 8%, the return on market portfolio is 14%, and Delta Ltd.'s beta is 1.4. If it
recently paid a dividend of Rs. 3.5 for the last accounting year and the expected growth rate is
10%, what should be its value per price? If its current market price is Rs. 65, should it be
bought?

Expected Earnings per share (EPS) of Sun Ltd. is Rs. 7 and expected dividend per share (DPS) is
Rs. 3.5. Company’s ROE is expected to be maintained at 20%. Investor’s required rate of return
for Sun Ltd. is 15%. What should be the value (or expected price) of its share? If current market
price is Rs. 74, should it be purchased?

Illustration 7
Today’s share price of Christ Edu Ltd is Rs. 18. The expected dividend from the share after a
year is Rs.2, and it is expected to grow at 5% per annum. What will be your advice on buyinf this
share today, if the share is held for 5 years and the opportunity cost of capital is 15 per cent? The
share is expected to sell at the end of 5 years for Rs.25.53.

Solution
P0 = [D1/(1+ke)1] + [D2/(1+ke)2] + …..+ [Dn/(1+ke)n] + [Pn/(1+ke)n]
D1 = Rs.2
D2 = D1 (1+g) = 2 * (1+0.05) = 2.10
D3 = D2 (1+g) = 2.1 * (1.05) = 2.21
D4 = D3 (1+g) = 2.21 * (1+0.05) =2.32
D5 = D4 (1+g) = 2.32 * (1+0.05) = 2.43
Therefore,
P0 = [2 / (1+0.15)1] + [2.1 / (1+0.15)2] + [2.21 / (1+0.15)3] + [2.32 / (1+0.154] [2.43/(1+0.15)5] +
[25.53/(1+0.15)5]
P0 = 7.31 + 12.69 = Rs.20
The intrinsic value (Rs.20) is more than the market value (Rs.18) of the share; it is advised to
buy the share today.

Exercise 7
Today’s share price of Janaki Ltd is Rs. 180. The expected dividend from the share after a year is
Rs.5, and it is expected to grow at 6% per annum. What will be your advice on buying this share
today, if the share is held for 6 years and the opportunity cost of capital is 12 per cent? The share
is expected to sell at the end of 5 years for Rs.40.

Super - Normal Growth

The dividends of the company may not grow at the same constant rate indefinitely. It may face a
stage wise growth situation. In the first stage, dividends may grow at a super – normal growth
rate when company is experiencing very high demand for its products and is able to extract
premium from customers. Afterwards, the demand for the company’s products may normalize
and therefore, earnings and dividends may grow at a normal growth rate.

Two stage growth situation

The share value in a two stage growth situation can be determined in two parts. First, we can find
the present value of constantly growing dividend annuity for a definite super-normal growth

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period. Second we can calculate the present value of constantly growing dividend, indefinitely
(in perpetuity), after the super normal growth period.
Steps
Step 1: Calculate expected dividend with 1st growth rate (g1) for the applicable number of years
(n). Suppose g1=10% for next 3 years (n=3), then D1, D2, D3 (for 3 years) need to be calculated
with growth rate of 10%. D1= D0 (1+.10); D2= D1(1+.10) and D3= D2(1+.10).
Step 2: Find present value of expected D1, D2, and D3 or up to Dn
Step 3: Calculate expected dividend (D4 or) for next year with a second growth rate (g2) i.e., D4
= D3 (1+g2)
Step 4: Find out the V3 i.e., (V3 = [D4 / (Ke-g2)]
Step 5: Find out the present value of V3 i.e., = [V3 / (1+ke) 2]
Step 6: Find out the intrinsic value of the share by adding the answer in Step 2 and Step 5

Illustration 8
HitechLtd. paid a dividend of Rs.5 per share for the previous accounting year. Growth rate is
expected to be 12% for next 3 years and 8% thereafter. Investor’s required rate of return is 18%.
What’s the value of share to the investor? If the current market price is Rs.62, should the investor
buy it?

Solution
Estimate D1 and D2using g = 12% and D3using g=8%
D1=5(1 + .12) = 5.6; D2= 5.6 (1 + .12) =6.27; D3= 6.27(1+.08) = 6.77
V0= (5.6/1.18) + 6.27/(1.18)^2+ ([6.77/(.18-.08)] (1/1.18)^2)
=4.75 + 4.5 + 48.6 =57.85
Decision: Since intrinsic value (Rs.57.85) < current market price (Rs. 62) investor should not
buy the share.
Illustration 8
A company earned Rs. 6 per share and paid Rs. 3.48 per share as dividend in the previous year.
Its earnings and dividends are expected to grow at 15 per cent for six years and then at a rate of 8
per cent indefinitely. The capitalization rate is 18 per cent. What is the price of the share today?

Solution
Step 1: Calculation of expected dividend with 1st growth rate (g1) for first 6 of years
D0 = 3.48; g1= 15%; n = 6 years
D1 = D0 (1+g)1
D1= 3.48 (1+0.15)1 = Rs.4.00
D2= 3.48 (1+0.15)2 = Rs.4.60
D3= 3.48 (1+0.15)3 = Rs.5.29
D4= 3.48 (1+0.15)4 = Rs.6.08
D5= 3.48 (1+0.15)5 = Rs.7.00
D6= 3.48 (1+0.15)6 = Rs.8.04

Step 2: Finding out present value of expected D1, D2, D3, D4, D5 and D6
= [Rs.4.00 / (1+0.18)1] + [Rs. 4.60/ (1+0.18)2] + [Rs. 5.29/ (1+0.183)] + [Rs. 6.08/ (1+0.18)4] +
[Rs. 7.00/ (1+0.18)5] + [Rs. 8.04/ (1+0.18)6]
= 3.39 + 3.30 + 3.22 + 3.14 + 3.06 + 2.99
= 19.10

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Step 3: Calculating expected dividend (D7) of 7th year with a second growth rate (g2=8%) i.e.,
D7 = D6 (1+g2) = 8.04 (1+0.08) = Rs.8.68

Step 4: Finding out the present value at 6th year for the dividends from the year 7 to indefinite
period 6
V6 = [D7 / (Ke-g2)]
= [8.68 / (0.18 – 0.08)]
= 86.8

Step 5: Find out the present value of V6

P0= [V6 / (1+ke)]6
= 86.8 / (1+0.18)6
= 86.8 / 2.70 = Rs. 32.15

Step 6: Finding out the intrinsic value of the share by adding the answer in Step 2 and Step 5
Intrinsic value = 19.10 + 32.15= Rs. 51.25

Three phase model

The three-stage model is applicable for the valuation of equity share of a company which has an
initial period of very aggressive growth followed by a period of incremental increase or decrease
that eventually stabilizes at a more moderate growth rate that is assumed to continue for the life
of the company. The formula for the three-stage dividend model is rather intimidating, but the
components are straightforward and simple to understand. Like simpler models, the three-stage
model requires only the value of the current dividend, the expected rate of return, the dividend
growth rates and number of years over which the dividend growth rate is expected to change.

Where,
H represents one-half of the duration of the transitionary period.

Illustration 9
‘Current’ dividend of Lockheed Ltd in 2019 is Rs.2.28. Dividends of the company grow at
18.4% each year for four years beginning in 2020, after which the growth rate declined by 2.8%
a year for an additional three years before stabilizing at 7.2% in 2027. The expected rate of
return of the investor is assumed to be 10%. Calculate value of the share.

Solution
N=4
The transitionary period is three years, so H = 1.5
The expected rate of return = 10%

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Current dividend in 2019 = Rs.2.28.

G1 = 18.4%
G2 = 7.2%
r = 10%

The expected dividends for 2020-2023, therefore, can be calculated as follows:

Dn = D0 (1+g)n
D1 = Rs.2.28 * (1+.184)1 = Rs. 2.70
D2 = Rs.2.28 * (1+.184)2 = Rs. 3.20
D3 = Rs.2.28 * (1+.184)3 = Rs. 3.79
D4 = Rs.2.28 * (1+.184)4 = Rs. 4.49

For any further readings

✓ Financial Management by I M Pandey, Vikas Publishing House Pvt Ltd.
✓ Investments, by Zvi Bodie, Alex Kane, Alan J Marcus and Pitabas Mohanty, Tata
McGraw Hill Education Pvt Ltd

Course Instructors and Material prepared by

Dr. M. Muthu Gopalakrishnan, Mr. Shbarisha N
Associate Professor, Asst. Professor
muthugopalakrishnan.m@christuniversity.in shabarisha.n@christuniversity.in

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