Security Valuation 02


Published on


Published in: Economy & Finance, Business
  • Be the first to comment

No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Security Valuation 02

  1. 1. Valuation Of Securities
  2. 2. Value of a Security <ul><li>In general, the value of an asset is the price that a willing and able buyer pays to a willing and able seller. If either the buyer or seller is not both willing and able, then an offer does not establish the value of the asset </li></ul><ul><li>There are several ways of calculating value </li></ul><ul><ul><li>Book Value - The asset’s historical cost less its accumulated depreciation </li></ul></ul><ul><ul><li>Market Value - The price of an asset as determined in a competitive marketplace </li></ul></ul><ul><ul><li>Intrinsic Value - The present value of the expected future cash flows discounted at the decision maker’s required rate of return </li></ul></ul>
  3. 3. Why does a trade happen? <ul><li>There are two primary determinants of the intrinsic value of an asset to an individual. </li></ul><ul><ul><li>The size and timing of the expected future cash flows </li></ul></ul><ul><ul><li>The individual’s required rate of return (this is determined by a number of other factors such as risk/return preferences, returns on competing investments, expected inflation, etc.) </li></ul></ul><ul><li>Note that the intrinsic value of an asset can be, and often is, different for each individual (that’s what makes markets work) </li></ul>
  4. 4. Types of Securities <ul><li>Bonds </li></ul><ul><ul><li>Tradeable instrument that represents a debt owed to the owner by the issuer. Bonds usually earn interest periodically and return the principal at maturity. </li></ul></ul><ul><ul><li>Terms </li></ul></ul><ul><ul><ul><li>Coupon Rate - This is the stated rate of interest on the bond. </li></ul></ul></ul><ul><ul><ul><li>Face Value - This is the principal amount (nominally, the amount that was borrowed and that will be repaid at maturity </li></ul></ul></ul><ul><ul><ul><li>Maturity Date - This is the date after which the bond no longer exists. It is also the date on which the loan is repaid and the last interest payment is made. </li></ul></ul></ul><ul><li>Shares </li></ul><ul><ul><li>A share of common stock represents an ownership position in the firm. Apart from rights to vote on important matters shares usually receive dividends and increase in tradeable value. </li></ul></ul>
  5. 5. Valuating Securities <ul><li>The NPV of the cash flows expected from a security is the value of the security </li></ul><ul><li>The NPV would be computed by discounting the cash flows at the required rate of return </li></ul>
  6. 6. Valuating Bonds <ul><li>Bonds provide two types of cash flow: </li></ul><ul><ul><li>An annuity of interest </li></ul></ul><ul><ul><li>Face value repayment at maturity </li></ul></ul><ul><ul><li>Value of the bond is the present value of the annuity-type cash flow and the maturity value </li></ul></ul><ul><li>Example </li></ul><ul><ul><li>Assume that you are interested in purchasing a bond with 5 years to maturity and a 10% coupon rate. If your required return is 12%, what is the highest price that you would be willing to pay? </li></ul></ul>0 1 2 3 4 5 100 100 100 100 100 1,000
  7. 7. Valuating Shares <ul><li>Shares provide two types of cash flow </li></ul><ul><ul><li>Dividend payments </li></ul></ul><ul><ul><li>The future selling price </li></ul></ul><ul><li>Valuing stock, however, is more complicated than valuing bonds because the cash flows are not contractually specified or fixed. </li></ul><ul><li>Example </li></ul><ul><ul><li>A share will pay dividend of 2 next year, and 2.16 the following year. After receiving the second dividend, the share can be sold for 33.33. What is the intrinsic value of this stock if your required return is 15%? </li></ul></ul><ul><ul><li>. </li></ul></ul>2.00 2.16 33.33 ?
  8. 8. Valuating Shares: The Gordon Model <ul><li>Dividend Discount Model (Gordon Model) </li></ul><ul><ul><li>Both of these assumptions are unrealistic, especially knowledge of the future selling price. Simplified workable assumptions required. </li></ul></ul><ul><ul><ul><li>Your holding period is infinite (i.e., you will never sell the stock) </li></ul></ul></ul><ul><ul><ul><li>The dividends will grow at a constant rate forever </li></ul></ul></ul><ul><ul><li>Note that the second assumption allows us to predict every future dividend, as long as we know the most recent dividend </li></ul></ul><ul><ul><li>This is a growing perpetuity </li></ul></ul><ul><li>Example: </li></ul><ul><ul><li>A share will pay dividend growing at 8% p.a. starting with 2 next year. What is the intrinsic value of this stock if your required return is 15%? What will be its price after 2 years? </li></ul></ul><ul><li>. </li></ul>
  9. 9. Valuating Preference Shares <ul><li>Preferred stock is very much like common stock, except that the dividends are constant (i.e., the growth rate is 0%) </li></ul><ul><li>Example: </li></ul><ul><ul><li>Suppose that you are interested in purchasing shares of a preferred stock which pays a $5 dividend every year. If your required return is 7%, what is the intrinsic value of this stock? </li></ul></ul>
  10. 10. Valuating by Balance Sheet figures <ul><li>Book value of Equity per share </li></ul><ul><ul><li>= (Total assets –Total liabilities) / number of shares outstanding </li></ul></ul><ul><ul><li>Asset valuation: </li></ul></ul><ul><ul><ul><li>Historical cost accounting: recorded at purchase prices </li></ul></ul></ul><ul><ul><ul><li>Liquidation value: selling prices of all of the firm’s assets minus debts </li></ul></ul></ul><ul><ul><ul><li>Replacement cost accounting: recorded at current market replacement costs </li></ul></ul></ul><ul><li>Example </li></ul><ul><ul><li>Intel’s assets in 2001 were $44.2 billion and its liabilities were $8.3 billion. Its equity is A- L = $35.9 billion. There were 6.7 billion shares outstanding. </li></ul></ul><ul><ul><li>This implies a book value of $5.35 per share. </li></ul></ul><ul><ul><li>At the same time, Intel shares were trading in the market place for $20 per share </li></ul></ul><ul><li>Why is there such a difference? </li></ul>
  11. 11. Interactive Session