Valuation of Securities for investors.pptx

Valuation of Securities

1. Topics to be discussed today Valuation Concepts Bond Valuation Preferred Stock Valuation Common Stock Valuation Rates of Return 1

2. Distinction among valuation concepts Value and Price

3. Liquidation Value Vs Going-Concern Value The term value can mean different things to different people Liquidation Value Amount of money that could be realized if an asset or a group of assets is sold separately from its operating organization. Going-Concern Value Amount the firm could be sold for as a continuing operating business. 3 These two values are rarely equal, and sometimes a company is actually worth more dead than alive The firm’s liquidation value has a major role in determining the value of the firm’s financial securities

4. Book Value vs Market Value The term value can mean different things to different people Book Value Asset : It is the accounting value of the asset. The asset’s cost minus its accumulated depreciation Firm : The dollar difference between the firm’s total assets and its liabilities and preferred stock. Market Value Asset : The market price at which the asset (or a similar asset) trades in an open marketplace. Firm: Market value is often viewed as being the higher of the firm’s liquidation or going-concern value 4

5. Market Value versus Intrinsic Value The term value can mean different things to different people Market Value The market value of a security is the market price of the security For an actively traded security, last reported price at which the security was sold. For an inactively traded security, Estimated market price. Intrinsic Value The intrinsic value of a security is what the price of a security should be if properly priced based on all factors assets, earnings, future prospects, management, and so on. It is the Economic value. 5 If markets are reasonably efficient and informed, the current market price of a security should fluctuate closely around its intrinsic value.

6. Bond valuation

7. Bond Fundamentals What is bond? Loans to corporations and governments Borrowers get cash; lenders earn interest Long term fixed income securities Different Issuers Government, Municipal, Corporations Different Styles Coupon bonds, Zero Coupon bonds

8. Bond Terminologies Par Value The Payment at maturity that is not part of a regular coupon payment Indenture It’s a legal stuff. Basically a written Agreement between the Entity & Bond holder. Covenants They are clauses of such an indenture. Covenants specify the rights of bondholders and the duties of issuers, such as actions that the issuer is obliged to perform or is prohibited from performing Discount Bond A bond that promises a single payment at a future date. Level Coupon Bond A Bond that pays equal coupon payments periodically prior to bond maturity. Yield to Maturity (YTM) Its an important number in bond valuation

9. Varieties of Bond Zero-coupon bonds Do not pay coupon payments and instead are issued at a discount to their par value that will generate a return once the bondholder is paid the full face value when the bond matures. Convertible bonds Debt instruments with an embedded option that allows bondholders to convert their debt into stock (equity) at some point, depending on certain conditions like the share price. Callable bonds A callable bond is one that can be “called” back by the company before it matures. Puttable bonds Allows the bondholders to put or sell the bond back to the company before it has matured.

10. Bond market in Bangladesh The corporate bond market in Bangladesh is almost non-existent , with only two bonds listed in the prime bourse at present . 1. APSCL Non-Convertible and Fully Redeemable Coupon Bearing Bond Non-Convertible Bonds : A Non-Convertible debenture/ bond do not have the option of conversion into shares and on maturity the principal amount along with accumulated interest is paid to the holder of the instrument. Redeemable Bonds : Redeemable bonds can be redeemed or paid off by the issuer before it reaches the date of its maturity. The issuer of such bonds is allowed to pay back its obligation to the bondholder before maturity. Coupon Bearing Bonds : The holder of a coupon-bearing bond receives periodic payment (semiannually, annually, etc ) during the life of the bond. The bondholders will get at the rate of 182-days Bangladesh Treasury Bill as published on Bangladesh Bank web site on fixing date along with 4% margin on due date. The range of the return of the APSCL bond is within the 8.5% - 10.0%.

11. 2. IBBL Mudaraba Perpetual Bond (MPB) Mudaraba is a form of business venture under Islamic Shariah in which one party brings capital and the other personal endeavor. The proportionate share in profit is determined by mutual agreement. But the loss, if any, is borne only by the owner of the capital—in which case the entrepreneur gets nothing for his labour . MPB is a subordinate instrument ; The bondholders will stand subordinated to the depositors get priority over the shareholders in respect of getting profit and also refund of principal in case of liquidation of the bank. Bond market in Bangladesh

12. Bond Returns Bond returns can be calculated in various ways Coupon rate Current yield Spot interest rate Yield to Maturity (YTM) Yield to call (YTC) Realized YTM

13. Coupon Rate It is the nominal rate of interest that is fixed and printed on the bond certificate It is calculated on the face value of the bond It is the rate at which interest is paid by the company to the bondholder It is payable by the company at periodical intervals of time till maturity Example: A bond has a face value of Tk. 1000 with an interest rate of return 12%. It means Tk. 120 will be paid by the company on an annual basis to the bond holder till maturity

14. Current Yield The current market price of the bond in the secondary market may differ from its face value (that is may be currently selling at a discount or at a premium). Current yield relates the annual interest receivable on a bond to its current market price Current yield = (Annual interest/Current market price )*100 It thus measures the annual return accruing to a bondholder who purchases the bond from the secondary market and sells it before maturity presumably at a price at which he bought the bond. Example: A bond has a face value of TK. 1000 and a coupon rate is 12% . It is currently selling for TK. 800 Solution: The current yield= 120/800*100=15% Current yield > coupon rate : when bond is selling at a discount  Current yield < coupon rate : when bond is selling at a premium

15. Spot Interest Rate Zero coupon bond or Deep discount bond is a special type of bond which does not pay annual interest Rather such bonds are issued at a discount to be redeemed at par The return comes in form of the difference between the issue price and the maturity value Spot interest rate is the return on deep discount bonds when expressed in % terms on an annual basis Mathematically it is that rate of discount which makes the present value of the single cash inflow to the investor (on redemption of bond, no interest being payable annually) equal to the cost of the bond Example: A zero coupon bond has a face value of Tk. 1000 and maturity period of five years. If the issue price of the bond is Tk. 519.37 , what is the spot interest rate? It is that rate of interest which makes the PV of 1000 = 519.37 519.37 = 1000 /(1 + i )^5 i = 0.14 or 14%

16. Yield to Maturity (YTM) It is the rate of return that an investor is expected to earn on an annualized basis expressed in % terms from a bond purchased at the current market price and held till maturity It is the internal rate of return earned on a bond if held till maturity YTM is that rate of discount (r) which makes the present value of cash inflows from the bond (in form of interest and redemption value) equal to the cash outflow on purchase of the bond i.e . MP = I * PVAF (r%, n) + RV * PVF (r%, n) Approximate YTM may be calculated as follows:

17. Example A bond of face value Tk. 1000 and a coupon rate of 15% is currently available at Tk. 900. Five years remain to maturity and bond is redeemable at par. Calculate YTM. MP = 900 RV = 1000 I = 15% of Rs 1000 = 150 N = 5 YTM = 0.1789 or 17.89%

18. Yield to Call (YTC) Some bonds may be redeemable before their full maturity at the option of the issuer or the investor In such cases, two yields are calculated: YTM (assuming that the bond will be redeemed only at the end of full maturity period) YTC (assuming that the bond will be redeemed at a call date before maturity ) YTC is computed on the assumption that the bond’s cash inflows are terminated at the call date with redemption of the bond at the specific call price Thus, YTC is that rate of discount which makes the present value of cash inflows till call equal to the current market price of the bond Same method as YTM would be used except for ‘N’ now being years remaining to call. If YTC > YTM , it would be advantageous to the investor to exercise the redemption option at the call date If YTM > YTC , it would be better to hold the bond till final maturity

19. Realized YTM The calculation of YTM assumes that cash flows received through the life of the bond are being reinvested at a rate equal to YTM However, the reinvestment rate may differ over time . In such cases, Realized YTM is a more appropriate measure.

20. Example A Tk. 1000 par value bond carrying a coupon rate of 15% maturing after 5 years is being considered. The present market price of this bond is Tk. 850. The reinvestment rate applicable to future cash flows is 16%. Calculate realised YTM. Total FVs=271.6+234.1+201.8+174+150+1000= 2032 calculating Realized YTM , MP (1+r) ^ 5 = 2032 850 (1+r) ^ 5 = 2032 r = 0.19 or 19% 1 2 3 4 5 Investment 850 Annual Interest 150 150 150 150 150 Reinvestment period @16% 4 3 2 1 FV of these CFs 271.6 234.1 201.8 174.0 150.0 Maturity Value 1000

21. Bond prices Intrinsic value of bond is equal to the present values of all future cash flows discounted at the required rate of return Po = I * PVAF (r%, n) + RV * PVF (r%, n) where, Po : Present value of the bond today I : Annual interest payments RV : Redemption value r : required rate of return n : number of years

22. Example A bond has a face value of Tk. 1000 and was issued five years ago at a coupon rate of 10%. The bond had a maturity period of 10 years. If the current market interest rate is 14%, what should be the PV of the bond? I = 1000 * 10% = 100 n = 5 RV = 1000 r = 14% Po = I * PVAF (r%, n) + RV * PVF (r%, n) = 100 * PVAF (14%, 5) + 1000 * PVF (14%, 5) = Tk. 862.71

23. Example If in the above question, interest is payable semi-annually , what would be the intrinsic value of the bond? I = 1000 * 10% * ½ = 50 n = 5 * 2 = 10 RV = 1000 r = 14% * ½ = 7% Po = I * PVAF (r%, n) + RV * PVF (r%, n) = 50 * PVAF (7%, 10) + 1000 * PVF (7%, 10) = Tk. 859.48

24. Bond pricing Bonds are issued at a fixed rate of interest payable on the face value which is referred to as COUPON RATE At the time of issue, coupon rate is representative of the then prevailing market interest rate However, subsequent changes in the market interest rates may have its affect on the bond prices If market interest rate rises above the coupon rate The existing bonds would start providing lower return Thus becoming unattractive Thus the price of the bond would fall below its face value i.e. the bond would start selling at a discount If market interest rate falls below the coupon rate The existing bonds would start providing relatively higher return Thus becoming very attractive Thus the price of the bond would rise above its face value i.e. the bond would start selling at a premium Long maturity bonds A change in interest rate structure would result in a relatively large price change in a long maturity bond

25. Bond risks Risk is the possibility of variation in returns The actual returns realized from investing in bond may vary from what was expected on account of: Default or delay on part of the issuer to pay interest or principal Change in market interest rates Thus there are two broad sources of risk associated with bonds: Default risk Interest rate risk

26. Default risk It refers to the possibility that a company may fail to pay the interest or principal on stipulated dates Poor financial performance of the company may lead to such default Credit rating of debt securities is a mechanism adopted for assessing the credit risk involved Credit rating process involves: Qualitative assessment of company’s business and management Quantitative assessment of company’s financial performance Specific features of the bond being issued Credit rating is an opinion of the credit rating agency regarding the relative ability of issuer of debt to fulfill the debt obligations in respect of interest and repayment

27. Interest rate risk It refers to variation in returns of bond because of a change in market interest rates Interest rate risk is composed of two risks: Reinvestment risk Price risk Reinvestment risk An investor in bonds receives interest annually or semi-annually He reinvests it each year at the then prevailing interest rate. Thus interest is earned on the interest received from the bonds each year If the market interest rate moves up, the investor would be able to reinvest the annual interest received from the bond at a higher rate than expected. Thus he would gain from the reinvestment activity When the market interest rates moves down, the investor would be able to reinvest the interest only at a lower rate than expected. Thus he would lose on reinvestment activity Price risk The price of the bond is inversely related to changes in market interest rate If the market interest rate moves up, bond price may decline below its face value. Thus the investor would suffer a loss while selling the bond If the market interest rate goes down, the existing bonds may start selling at a premium. Thus the investor would gain from sale of such bond Thus, reinvestment risk and price risk are inversely related. Together they constitute interest rate risk

28. Sariah Compliant Bond ( Sukuk ) “Certificates of equal value representing undivided shares in the ownership of tangible assets, usufructs and services or (in the ownership of) the assets of particular projects or special investment activities.” First, the certificates must represent ownership in tangible assets, usufructs or services from revenue-generating firms. Second, payments to the investor come from after-tax profits and third, the value repaid at maturity date should follow the current market price of the underlying asset and not the original invested amount. Fundamentally the parties within a Sukuk issuance are: The firm (the obligor or originator), The Special Purpose Vehicle (SPV)and The investors that buy the Sukuk . The SPV is a bankruptcy-remote entity, separate from the originator, which issues Sukuk certificate.

29. Sukuk ; Equity or Bonds? While the conventional bonds price is determined only by the creditworthiness of the issuer, Sukuk price is determined by the creditworthiness of the issuer and the value of the asset. Although Sukuk is also similar to stocks in the sense that it represents ownership and no guarantee of a fixed return (at least theoretically and in the standard model of Sukuk ) but stocks have no maturity date. Sukuk also has to relate to a specific asset, project or service.

30. Sukuk : Ijara

31. Preferred Stock 31 A type of stock that promises a (usually) fixed dividend, but at the discretion of the board of directors. It has preference over common stock in the payment of dividends and claims on assets.

32. Preferred stock valuation Most preferred stock pays a fixed dividend at regular. Preferred stock has no stated maturity date and, given the fixed nature of its payments, is similar to a perpetual bond. Thus the present value of preferred stock is V = D p / k p Dp =Annual dividend per share of preferred stock. kp =the appropriate discount rate. Overview 32

33. Preferred stock valuation Share of preferred stock for the Buford Pusser Baseball Bat Company had a 8 percent, $100-par-value preferred stock issue outstanding and your required return was 14 percent on this investment. Thus the present value of preferred stock is V = D p / k p Dp =Annual dividend per share of preferred stock=$8 kp =the appropriate discount rate=0.14 Thus, Present value of preferred stock is V=$8/0.14=$57.14 Example 33

34. Common stock 34 Securities that represent the ultimate ownership (and risk) position in a corporation.

35. Common stock valuation The value of a share of common stock can be viewed as the discounted value of all expected cash dividends provided by the issuing firm until the end of time Dividend as Foundation 35 where D t =is the cash dividend at the end of time period t and k e =the investor’s required return, or capitalization rate, for this equity investment.

36. Common stock valuation if we plan to own the stock for only two years? In this case, our model becomes Dividend as Foundation 36 Where, P 2 = the expected sales price of our stock at the end of two years. . Future investors’ judgement is based on Expectation of future dividends A future selling price which itself is based on expected future dividends

37. Common stock valuation Dividend as Foundation 37 It is the expectation of future dividends and a future selling price, which itself is based on expected future dividends, that gives value to the stock. Consequently, the foundation for the valuation of common stock must be dividends. However, stock companies with zero dividend have often quite high value. Investors expect to sell the stock in the future at a price higher than they paid for it. Instead of dividend income plus a terminal value, they rely only on the terminal value. The ultimate expectation is that the firm will eventually pay dividends, either regular or liquidating, and that future investors will receive a company-provided cash return on their investment

38. Common stock valuation Dividend Discount Model-Constant Growth 38 If dividends are expected to grow at a constant rate, If this constant rate is g Rearranging, the investor’s required return can be expressed as, k e = ( D 1 / V ) + g Assuming that k e is greater g, The Equation can be reduced to V = D 1 /( k e - g ) where, D 1 =D (1+g)

39. Common stock valuation Dividend Discount Model-Constant Growth-Example 39 Suppose dividends for a particular company are projected to grow at 5 percent forever. If the discount rate is 15 percent and dividend per share after 1 year is expected to be $10, what is the value of the stock? Solution: Here, D 1 = Expected dividend after 1 year k e =Discount Rate= 0.15 g =Growth Rate=0.05 Thus, The value of one share of LKN stock would be V = $10/(0.15 − 0.05) = $100

40. Common stock valuation Conversion to an Earnings Multiplier Approach 40 If a company retains a constant proportion “b” of its earnings each year, the value of share would be. Step 1 Step 2 Step 3

41. Common stock valuation Dividend Discount Model-Constant Growth-Example 41 Suppose dividends for a particular company are projected to grow at 5 percent forever. If the discount rate is 15 percent and dividend per share after 1 year is expected to be $10. The company has a retention rate of 40 percent and earning per share for period 1 are expected to be $16.67. what is the value of the stock? Solution: Here, b=Retention rate of earning=0.4 E 1 =Expected Earning=$16.67 k e =Discount Rate= 0.15 g =Growth Rate=0.05 Thus, The value of one share of LKN stock would be V = [(0.60)$6.67]/(0.14 − 0.06) = $100

42. Common stock valuation Dividend Discount Model-Growth Phases 42 Expected dividend growth is such that a constant growth rate model is not appropriate In the beginning years, firms may exhibit above-normal growth for a number of years. After few years, the growth rate will taper off. If dividends per share are expected to grow at a 10 percent compound rate for five years and thereafter at a 6 percent rate, the equation for valuation of common stock would become,

43. Common stock valuation Two Phase Growth-Example 43 Delphi Products Corporation currently pays a dividend of $2 per share, and this dividend is expected to grow at a 15 percent annual rate for three years, and then at a 10 percent rate for the next three years, after which it is expected to grow at a 5 percent rate forever. What value would you place on the stock if an 18 percent rate of return was required? Solution: The equation can be written as, + + Or, + +  

44. Common stock valuation Two Phase Growth-Example 44

45. Common stock valuation Two Phase Growth-Example 45

46. Rates of return(yields) 46 Yield to Maturity (YTM) on Bonds Yield on Preferred Stock Yield on Common Stock

47. YEILD To maturity (YTM) The expected rate of return on a bond if bought at its current market price and held to maturity. Market required rate of return on a bond is more commonly referred to as the bond’s yield to maturity. 47

48. Behavior of bond prices When the market required rate of return is more than the stated coupon rate, the price of the bond will be less than its face value. Such a bond is said to be selling at a discount from face value. The amount by which the face value exceeds the current price is the bond discount . Yield to Maturity (YTM) > Coupon Rate; Price of the bond < Face value of the bond 48

49. Behavior of bond prices When the market required rate of return is less than the stated coupon rate, the price of the bond will be more than its face value. Such a bond is said to be selling at a premium over face value. The amount by which the current price exceeds the face value is the bond premium . Yield to Maturity (YTM) < Coupon Rate; Price of the bond > Face value of the bond 49

50. Behavior of bond prices When the market required rate of return equals the stated coupon rate, the price of the bond will equal its face value. Such a bond is said to be selling at par. Yield to Maturity (YTM) = Coupon Rate; Price of the bond = Face value of the bond 50

51. Behavior of bond prices If interest rates rise so that the market required rate of return increases , the bond’s price will fall. If interest rates fall , the bond’s price will increase. In short, interest rates and bond prices move in opposite directions – just like two ends of a child’s seesaw. Interest Rate ↑ Bond Price ↓ Interest Rate ↓ Bond Price ↑ 51

52. Behavior of bond prices For a given change in market required return, the price of a bond will change by a greater amount, the longer its maturity. 52

53. Behavior of bond prices For a given change in market required rate of return, the price of a bond will change by proportionally more, the lower the coupon rate. In other words, bond price volatility is inversely related to coupon rate. bond price change is inversely related to coupon rate. 53

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