security

valuati
SECURITY VALUATION

LEARNING
OUTCOMES
Apply fundamental and technical
analysis methods to value
securities.

0 Evaluate the efficiency of

financial markets based on the
Efficient market (EMH).

0
1
Interpret valuation models to
identify mispriced securities and
investment opportunities.

0
SECURITY VALUATION
Security valuation is the process of determining the intrinsic value of financial assets such as stocks, bonds,
or other investment instruments. This process aims to assess what these securities are genuinely worth
based on various financial metrics and market conditions.

Security Investment is a process in which regulators assess the safety and risk associated with the securities
that an insurance company has on its books. The purpose of doing this is to make sure that the insurance
company is not exposed to high levels of risk, thereby putting policyholders in danger of massive losses.
 STOCK
VALUATION

In Financial Market
stock valuation is the
method calculating
theoretical values of
Companies and their
Common Stock
Unlike bonds, valuating common stock is more difficult why?

Valuation
The timing and amount of future cash flows is not known

The life of investment is essentially forever

There's no way to observe the rate of return that the market requires
 Common Stock
To help us value a dividend of a stock, we need to make three simple
assumptions about the pattern of future dividend

Valuation
The three cases are:

• The dividend has zero growth rate

• The dividend grows at a constant rate
• The dividend grows at a constant rate
after some length of time
 Common Stock Features
 The term common stock usually implies that the shareholder has no special preference either in dividend or in
bankruptcy.
 Shareholders however control the corporation through their rights to elect the directors. The directors in turn hire
management to carry out their directives.
 Directors are elected on an annual shareholders' meeting by a holding of a majority of shares present and entitled to
vote.

Share holders usually have the following rights also

1.Right to vote on stockholder matters of great importance such as merger or new share
issuance

2.Right to share proportionally in assets remaining after liabilities and preferred

shareholders have been paid in liquidation

3.Right to share proportionally in dividends

 Classes of Common
Some firms have more than one class of common stock; often, the classes are created with
unequal voting rights.
Stock
« Canadian tire corporation is an example of a company with non-voting common stock
trading in the market
« Non-voting shares must receive dividends no lower than voting shares.
« A primary reason for creating dual classes of stock has to do with control of the firm
 Zero Growth Model
The zero growth dividend growth model assumes that the stock will pay the
same dividend each year, year after year.

Formula:
Po= D1/r
Example: The dividend of Denham Company, an established textile manufacture
is expected to remain constant at $3 per share indefinitely. What is the value of
Denham's stock if the required return demanded by investors is 15%?
Constant Growth
The constant dividend growth model assumes that the stock will

Model
pay dividends that grow at a constant rate each year, year after
year forever.

Formula Po= D1/(r-g)

For example, consider a company that pays a $5 dividend per
share, requires a 10 percent rate of return from investors and is
seeing its dividend grow at a 5 percent rate. what is the value of
that company share?
 Retained
Earning
Retained earnings represent a business cumulative

earning since its inception that if has not paid out

as dividends to common share holders.

 Cost of New
Equity
The cost of a newly issued common stock that

takes into account the flotation cost of the new

issue
 Flotation Cost
Flotation costs are incurred by a publicly treated company when it issues new Securities and includes expense underwriting fees legal

fees and registration fees

The following formula is used to calculate cost of new equity:

Cost of New Equity = D1

POx (1-F) Where,

D1 is dividend in next period

PO is the issue price of a share of stock

F is the ratio of flotation cost to the issue price

g is the dividend growth rate

XY Systems raised $300 million in fresh issue of commons stocks. The issue price was $25 per share, 4% of which was paid to the

investment bankers. The company is expected to pay $2 in dividend per share next year. Dividends are expected to increase by 5% per

year. Calculate the cost of new equity and compare it to the cost of (existing) equity
Components of Required
Return
Components of Required
Return
 1.Dividend grow at a
Infinite constant rate.

Period
Dividend 2.The constant growth

Discount rate will continue for an

infinite period.
Model and
Growth
3. The required rate of return (k)
is greater than the infinite growth

Companies
rate (g). If it is not, the model
gives meaningless result because
the denominator becomes
negative.
 Present value of operating free
cash flow
In this model, you are delivering the value of the total firm because you are discounting the

operating free cash flow prior to the payment of interest to the debt holders but after

deducting funds needed to maintain the firms asset base(capital expenditures). Also you are

discounting the firms total operating free cash flow, you would use the firms weighted average

cist of capital(WACC)as your discount rate. So, once you estimate the value of the total firm,
 The total value of the firm is equal to: Vj=
ΣΟFCFt/(1+WACCJ)^t

Where:

Vj=Value of the firm

n=Number of periods assumed to be infinite
OFCF=Operating free cash flow at the period 't'.

WACCj=Firms 'j' Weighted average cost of capital

PRESENT VALUE OF FREE
CASH FLOWS TO EQUITY
The third discounted cash flow technique deals with free cash
flows to equity, which would be derived after operating have been
adjusted for debt payments(interest and principal). Also, these
cash flows precede dividend payments to the common
stockholder. Such cash flows are referred to as free because they
are what is left after providing the funds needed to maintain the
firms asset base(similar to the operating free cash flow). They're
specified as free cash flows to equity because they also adjust for
payments to debt holders and to preferred stockholders. Notably,
because these are cash flows available to equity owners, the
discount rate used is the firms cost of equity (k) rather than firms
WACC.
PRESENT VALUE OF FREE
CASH FLOWS TO EQUITY
Vj=2FCFEJ/(1+Kj)^t

where;

vj=value of the stock of firm j n=number of the year assumed to

be infinite FCFEj=the firms free cash flow to equity in period t.
 The P/E Ratio or 'Price to Earnings' Ratio looks at the relationship between a stock price and
company's earnings

 It is a valuation ratio of a company's current share price to its per share earnings

 It is sometimes also referred to as 'Price Multiple' or 'Earnings Multiple'

 The P/E Ratio is the most popular metric of stock analysis, though not

PE is calculated as...

PE = Market Value per share

Annual earnings per share

• The market value per share (numerator) is the

current market price of a single share

• The annual earnings per share (denominator) is

the net income of the company for the most recent 12 months period divided by number of outstanding shares of the company

So, annual earning Per Share (EPS) = Net Income

No. of shares
For example...

A company having share price of Rs. 40 and Earning Per share (EPS) of Rs. 8 would have a Pi E ratio of
Rs. 5

P/E Ratio = Rs. 40/Rs. 8 = Rs. 5

But what does this P/E ratio tell you?

Essentially, the P/E Ratio gives you an idea of what the market is willing to pay for the company's
earnings
Simply speaking, the Price-to-book ratio (i.e. P/B ratio) is the
ratio of Price of a stock to that of the value of its tangible
assets and is used to compare a stock's market value to its
book value.

Book value is an accounting term denoting the tangible value

of the company. It is the total tangible value made up of the
assets of the company. Intangibles like "brand" name and
"goodwill" are not a part of the book value.
 It is calculated as:

P/B Ratio = Stock Price

Total Assets -
Intangible Assets
and Liabilities

What: The Price-to-book ratio (i.e. P/B ratio) is used to compare a stock's market value to its book value.

How: It is calculated by dividing the current closing price of the stock by the latest quarter's book value
per share.

Why: This ratio guards you against paying a very high price for a company because it compares the price
to what you could recover if the company were to suddenly close down.
Price-to-Sales (P/S) Ratio
The price-to-sales (P/S) ratio is a valuation ratio that
compares a company's stock price to its revenues. It is
an indicator of the value placed on each dollar of a
company's sales or revenues.
THANK
YOU!