An Introduction To Security Valuation: Dr. Amir Rafique

An Introduction to
Security Valuation
Dr. Amir Rafique

Theory of Valuation
 The value of an asset is the present value of its
expected future returns/ benefits/ cash flows
 This requires estimates of:

 The stream of expected returns/ cash flows, and
 The required rate of return on the investment
Theory of Valuation
 Investment Decision Process: A Comparison of
Estimated/ Intrinsic/ True Values and Market
Prices
 Calculate the intrinsic value of the investment and

then compare with the prevailing market price
 If Estimated Value > Market Price, Buy (Undervalued)

 If Estimated Value < Market Price, Don’t Buy (Overvalued)
Valuation of Alternative
Investments
 Bond Valuation
 Preferred Stock Valuation
 Common Stock Valuation

Valuation of Bonds
 The value, or price, of any asset is present value of
its future cash flows
 Same process for bonds as to value any financial asset
 Estimate expected future cash flows

 Coupons payments
 The principal at maturity
 Bond’s required rate of return, or discount rate

 This is the market interest rate
Valuation of Bonds
 Valuation of Bonds is relatively easy because
the size and time pattern of cash flows from
the bond over its life are known
 Coupon payments are made on regular basis
 The principal is repaid on the bond’s maturity date

Valuation of Bonds
• Compute current value of a bond (PB) by calculating
the present value of bond’s expected cash flows:
• PB = PV (Coupon payments)
+ PV (Principal payments)
• The general equation for the price of a bond can

be written as follows:
C1 C2 Cn  Fn
PB    ... 
1  i (1  i) 2
(1  i) n
PV of a Three-Year Bond
Valuation of Bonds
 Example: in 2003, a $10,000 bond due in 2018
with 10% coupon will pay $500 every six months
for its 15-year life
 Discount these payments at the investor’s

required rate of return of 10%
 PVAF=15.3725
 PVF=.2314
Valuation of Bonds
 Present value of the interest payments is an annuity
for thirty periods at one-half the required rate of
return:
$500 x 15.3725 = $7,686
 The present value of the principal is similarly

discounted:
$10,000 x .2314 = $2,314
Total value of bond at 10 percent = $10,000
 When to buy or sell?

Valuation of Preferred Stock
 Owner of preferred stock receives a promise to pay
a stated dividend, for perpetuity
 The value is simply the stated annual dividend

divided by the required rate of return (kp)
Dividend D
V  P0 =
kp R
OGDCL has a preference share issue that pays a
dividend of Rs. 5 per year. Investors require an 18 per
cent return on such an investment. What should be the
value of the preference shares? (Assuming Rs. 100 Par)
P0  ?
Make decisions:
• If the market price of the share is Rs. 30
• What if it is Rs. 25
Valuation of Common Stock
Valuation of Common Stock
Approaches to Valuation
Discounted Cash Flow Relative Valuation

Techniques Techniques
• Present Value of Dividends (DDM) • Price/Earnings Ratio (PE)
•Present Value of Free Cash Flow to Firm •Price/Cash flow ratio (P/CF)
•Present Value of Free Cash Flow to Equity •Price/Book Value Ratio (P/BV)
•Price/Sales Ratio (P/S)
Discounted Cash-Flow
Valuation Techniques
t n
CFt
Vj  
t 1 (1  k ) t
Where:
Vj = value of stock j
n = life of the asset
CFt = cash flow in period t
k = the discount rate that is equal to the investor’s required rate
of return for asset j, which is determined by the uncertainty
(risk) of the stock’s cash flows
The Dividend Discount Model
(DDM)
 The value of a share of common stock is the
present value of all future dividends
D1 D2 D3 D
Vj     ... 
(1  k ) (1  k ) 2
(1  k ) 3
(1  k ) 
n
Dt

t 1 (1  k ) t
Where:
Vj = value of common stock j
Dt = dividend during time period t
k = required rate of return on stock j
(DDM)
 Infinite period model assumes a constant
growth rate for estimating future dividends
D0 (1  g ) D0 (1  g ) 2 D0 (1  g ) n
Vj    ... 
Where:
(1  k ) (1  k ) 2
(1  k ) n
Vj = value of stock j
D0 = dividend payment in the current period
g = the constant growth rate of dividends
k = required rate of return on stock j
n = the number of periods, which we assume to be infinite
(DDM)
 Future dividend steam will grow at a constant rate
for an infinite period
D0 (1  g ) D0 (1  g ) 2 D0 (1  g ) n
Vj    ... 
(1  k ) (1  k ) 2
(1  k ) n
 This can be reduced to: D1

Vj 
 Estimate the required rate of return (k) kg
 Estimate the dividend growth rate (g)
(DDM)-Assumptions
D1
 Assumptions of DDM: Vj 
kg
 Dividends grow at a constant rate
 The constant growth rate will continue for an

infinite period
 The required rate of return (k) is greater than the

infinite growth rate (g)
Examples
A firm has a current dividend (D0) of €2.50, R is 15 per

cent, and g is 5 per cent. What is the price of the share
today (P0) and what will it be in five years (P5)?
D1
P0  ?
Rg
D6
P5  ?
Rg
Examples
A firm has a current dividend (D0) of €2.50, R is 15 per
cent, and g is 5 per cent. What is the price of the share
today (P0) and what will it be in five years (P5)?
D1  D0  1  g   €2.50  1.05  €2.625

D1 €2.625 €2.625
P0     €26.25
R  g 0.15  0.05 0.10
D6  D0  1 g   €2.50  1.05  €2.50  1.34  €3.35

6 6
D6 €3.35 €3.35
P5    €33.50
R  g 0.15  0.05 0.10
Present Value of
Free Cash Flow to Firm
 Derive the value of the total firm by
discounting the total cash flows prior to the
payment of interest to the debt-holders
 Then subtract the value of debt and other

liabilities to arrive at an estimate of the value
of the equity
FCF From Income Statement/
Balance Sheet
Start with PAT Start with EBIT
Profit after tax EBIT*(1-tax)
+ Depreciation + Depreciation
 D Current assets  D Current assets
+ D Current liabilities + D Current liabilities
 Capex  Capex
+ (1-tax)*Net interest
Present Value of
t n
FCFt
Vj  
t 1 (1  WACC j ) t
Where:
Vj = value of firm j
n = number of periods assumed to be infinite
FCFt = the firms free cash flow in period t
WACC = firm j’s weighted average cost of capital
Present Value of
 Similar to DDM, this model can be used to
estimate an infinite period
 Where growth has matured to a stable rate,
the adaptation is
OCF1
Vj 
Where:
WACC j  g OCF
OCF1=operating free cash flow in period 1

gOCF = long-term constant growth of operating free
cash flow
Present Value of
Free Cash Flows to Equity
 “Free” cash flows to equity are derived after
operating cash flows have been adjusted for
debt payments
 The discount rate used is the firm’s cost of

equity (k) rather than WACC
Present Value of
Free Cash Flows to Equity
n
FCFEt
Vj  
t 1 (1  k j )
t
Where:
Vj = Value of the stock of firm j
n = number of periods assumed to be infinite
FCFEt = the firm’s free cash flow in period t
K j = the cost of equity
Relative Valuation Techniques
Relative Valuation Techniques
 Comparables (comps) or price multiples
 Comparison of similar stocks based on relative

ratios
 Relative valuation ratios include price/earning;

price/cash flow; price/book value and price/sales
 Undervalued securities
 Overvalued securities
Estimating the Inputs: k and g
Estimating the Inputs: k and g
 Valuation procedure is the same for securities
around the world
 The two most important input variables are :

 The required rate of return (k)
 The expected growth rate (g)
 These two input variables differ among countries

Expected Growth Rate
 Estimating Growth Based on History
 Historical growth rates of sales, earnings, cash

flow, and dividends
 Arithmetic or geometric average of annual

percentage changes
Issues

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An Introduction to

Dr. Amir Rafique

 This requires estimates of:

 Calculate the intrinsic value of the investment and

 If Estimated Value > Market Price, Buy (Undervalued)

 Preferred Stock Valuation

 Common Stock Valuation

 Estimate expected future cash flows

 Bond’s required rate of return, or discount rate

 Coupon payments are made on regular basis

 The principal is repaid on the bond’s maturity date

• The general equation for the price of a bond can

 Discount these payments at the investor’s

 The present value of the principal is similarly

 When to buy or sell?

 The value is simply the stated annual dividend

Discounted Cash Flow Relative Valuation

 This can be reduced to: D1

 The constant growth rate will continue for an

 The required rate of return (k) is greater than the

A firm has a current dividend (D0) of €2.50, R is 15 per

D1  D0  1  g   €2.50  1.05  €2.625

D6  D0  1 g   €2.50  1.05  €2.50  1.34  €3.35

 Then subtract the value of debt and other

OCF1=operating free cash flow in period 1

 The discount rate used is the firm’s cost of

 Comparison of similar stocks based on relative

 Relative valuation ratios include price/earning;

 The two most important input variables are :

 These two input variables differ among countries

 Historical growth rates of sales, earnings, cash

 Arithmetic or geometric average of annual

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