Valuation of Securities
Valuation
Investment is an activity that is engaged in by people who
have savings, that is investments are made from savings.
Other word People invest their savings.
L.J. Gitman’’ Valuation is the process that links risk and
return to determine the worth of an assets”.
Share valuation
• According to Donald E. Fischer & Ronald J.
Jordan “Investment may be defined as a commitment
of funds made in the expectation of some positive rate
of return”
• V. K. Bhalla “Investment is the sacrifice of certain
present value for the uncertain future reward”
• Bodie, Alex Kane & Alan J Marcus “ An investment is
the current commitment of money or other resources in
the expectation of repaying future benefits”
Share valuation model
•One
year holding Period
S0
Where D1 =Dividend expected to be received at the end of the year
S1 =Selling Price expected to be received at the end of the year
k = rate of Interest required to the investor
Multiple year holding period
S0+
Prob-1
A share is currently selling for Tk. 65. The company is expected
to pay a dividend of Tk. 2.50 on that share at the end of the year.
It is reliably estimated that the share will sell for Tk. 78 at the
end of the year.
1. Assuming that the dividend and price forecasts are accurate
Constant growth Model
• Safety: The safety of an investment implies the certainty of
return of capital without loss of money or time.
• Liquidity: An investment which is easily saleable or
marketable without loss of money and without loss of time is
said to posses liquidity.
Problem 1
•Suppose
a investor interested to purchase a share which is
sold at TK 120 that the company will pay a dividend of TK.
5 in the next. Moreover he expects to sell the share at TK.
175 after one year. Calculate Expected return from this
investment.
Forecasted Dividend + Forecasted end of the period stock price
R= -1
Initial Investment
Alternatively R= +
R= (5+175)/120-1=0.50 =50%
Problem 2
•Shayla
purchased 100 shares of common stock for Tk.
4000 plus Tk. 100 commission in a single year. She sold
the stock for Tk. 4500 less a Tk. 100 commission. During
the year, she received Tk. 250 in dividends. What was the
rate return?
R= +
R= +
=+
= 550/4100
=0.1341
=13.41%
Weighted Expected Return
The expected return of he investment is the probability weighted
average of all the possible returns.
Where returns are denoted by X and the related probabilities are
P(Xi) and the expected return represented as X
X ∞
¿ ∑ 𝑋𝑖𝑃 (𝑋𝑖 )
𝑛=1
Risk Measurement (Page60)
•The expected returns are insufficient for decision making.
The risk aspect should also be considered. The most
popular measure of risk is the variance or standard
deviation of the probability distribution of possible
returns.
Possible Deviation
Probability Deviation Product
return Xip(Xi) Squared
p(Xi) (Xi-X) (Xi-X)2p(Xi)
(Xi) (Xi-X)2
30 0.10 3.00 -18 324 32.4
40 0.30 12.00 -8 64 19.2
50 0.40 20.00 2 4 1.6
60 0.10 6.00 12 144 14.4
70 0.10 7.00 22 484 48.4
48.00 116
Problem 3
An investor has analyzed a share for a one year
holding period. The share is currently selling for
Tk. 43 but pays no dividends and there is a fifty-
fifty chance that the share will sell for either Tk.
55 or Tk. 60 by the year end. What is the
expected return and risk if 250 shares are
acquired with 80% borrowed funds? Assuming
the cost of borrowed funds to be 12 % ignoring
commission and taxes. ex4
Measurement of systematic Risk
The systematic risk of a security is measured by a statistical
measure called Beta. For calculating Beta , requirements are
The historical data of returns of the individual security.
Return of the representative stock market index.
Two statistical methods may be used for the calculation of Beta
which are
• The correlation method .
• The regression method.
The Correlation Method
•
βi
• Where =Correlation coefficient between the returns of
stock i and the returns of the market index.
• = Standard deviation of returns of stock i,
• = Standard deviation of returns of the market index.
• = Variance of the market returns
Bond
Public bonds are long-term, fixed-obligation debt securities
packaged in convenient, affordable denominations for sale to
individuals and financial institutions.
A corporate bond is a debt instrument indicating that a
corporation has borrowed a certain amount of money and
promise to repay it in the future under clearly defined terms-
L.J. Gitman
A bond is a long term promissory note issued by a business
or government unit- Basely and Brigham.
BASIC FEATURES OF A BOND
Bond issues are considered fixed-income securities because they
impose fixed financial obligations on the issuers. Specifically, the
issuer of a bond agrees to:
1. Pay a fixed amount of interest periodically to the holder of
record
2. Repay a fixed amount of principal at the date of maturity
Types of Public debt market
Interest on bonds is paid every six months, although some bond
issues pay in intervals as short as a month or as long as a year. A
bond has a specified term to maturity, which defines the life of
the issue. The public debt market typically is divided into three
time segments based on an issue’s original maturity:
1. Short-term issues with maturities of one year or less. The
market for these instruments is commonly known as the
money market.
2. Intermediate-term issues with maturities in excess of 1 year
but less than 10 years. These instruments are known as notes.
3. Long-term obligations with maturities in excess of 10 years,
called bonds.
Bond Characteristics
A bond can be characterized based on
(1) its intrinsic features,
(2) its type,
(3) its indenture provisions, or
(4) the features that affect its cash flows and/or its maturity.
Intrinsic Features
The coupon, maturity, principal value, and the type of ownership are
important intrinsic features of a bond.
The coupon of a bond indicates the income that the bond investor will
receive over the life (or holding period) of the issue. This is known as
interest income, coupon income, or nominal yield.
The term to maturity specifies the date or the number of years before a
bond matures (or expires). There are two different types of maturity.
The most common is a term bond, which has a single maturity date.
Alternatively, a serial obligation bond issue has a series of maturity
dates, perhaps 20 or 25.
The principal, or par value, of an issue represents the original
value of the obligation.
If the market interest rate is above the coupon rate, the bond will
sell at a discount to par.
If the market rate is below the bond’s coupon, it will sell at a
premium above par. If the coupon is comparable to the prevailing
market interest rate, the market value of the bond will be close to its
original principal value.
Finally, bonds differ in terms of ownership. With a bearer bond,
the holder, or bearer, is the owner, so the issuer keeps no record of
ownership. Interest from a bearer bond is obtained by clipping
coupons attached to the bonds and sending them to the issuer for
payment. In contrast, the issuers of registered bonds maintain
records of owners and pay the interest directly to the current owner
of record.
Types of Issues
In contrast to common stock, companies can have many different
bond issues outstanding at the same time. Bonds can have
different types of collateral and be either senior, unsecured, or
subordinated (junior) securities.
Secured (senior) bonds are backed by a legal claim on some
specified property of the issuer in the case of default.
Unsecured bonds (debentures) are backed only by the promise
of the issuer to pay interest and principal on a timely basis. As
such, they are secured by the general credit of the issuer.
Subordinate (junior) debentures possess a claim on income and
assets that is subordinated to other debentures. Income issues are
the most junior type because interest on them is paid only if it is
earned.
Indenture Provisions
The indenture is the contract between the issuer and the
bondholder specifying the issuer’s legal requirements. A trustee
(usually a bank) acting on behalf of the bondholders ensures that
all the indenture provisions are met, including the timely
payment of interest and principal.
Features Affecting a Bond’s Maturity
Investors should be aware of the three alternative call option
features that can affect the life (maturity) of a bond.
One extreme is a freely callable provision that allows the
issuer to retire the bond at any time with a typical notification
period of 30 to 60 days.
The other extreme is a non-callable provision wherein the
issuer cannot retire the bond prior to its maturity.
Intermediate between these is a deferred call provision, which
means the issue cannot be called for a certain period of time
after the date of issue (e.g., 5 to 10 years). At the end of the
deferred call period, the issue becomes freely callable.
Callable bonds have a call premium, which is the amount
above maturity value that the issuer must pay to the
bondholder for prematurely retiring the bond.
