ERPM

Unit 2
Equity valuation
Basic Types of Models
Balance Sheet Models
Dividend Discount Models
Price/Earning Ratios
Estimating Growth Rates and
Opportunities
Models of Equity Valuation
Balance sheet Models
Book Value Method = NW of Co./ No.of
shares

Liquidation Value Method = (Value realised
by liquidating all assets of firm- Amt paid to
creditors & pref. shareholders)/No.of shares

Replacement cost

Intrinsic Value
Self assigned Value
Variety of models are used for estimation
Market Price
Consensus value of all potential traders
Trading Signal
IV > MP Buy
IV < MP Sell or Short Sell
IV = MP Hold or Fairly Priced

Intrinsic Value and Market Price
V
D
k
o
t
t
t
=
+
=

( ) 1
1
V
0
= Value of Stock
D
t
= Dividend
k = required return
Dividend Discount Models: General
Model
V
D
k
o =
Stocks that have earnings and dividends that are
expected to remain constant.
Preferred Stock
No Growth Model
E
1
= D
1
= Rs. 5.00
k = .15
V
0
= Rs. 5.00 / .15 = Rs. 33.33
V
D
k
o =
No Growth Model: Example
Vo
D g
k g
o
=
+

( ) 1
g = constant perpetual growth rate
Constant Growth Model
Vo
D g
k g
o
=
+

( ) 1
E
1
= Rs. 5.00 b = 40% k = 15%
(1-b) = 60% D
1
= Rs. 3.00 g = 8%
V
0
= 3.00 / (.15 - .08) = Rs. 42.86
Constant Growth Model: Example
g ROE b =
g = growth rate in dividends
ROE = Return on Equity for the firm
b = plough back or retention percentage rate
(1- dividend payout percentage rate)
Estimating Dividend Growth Rates
) 1 ( ) 1 ( ) 1 (
...
2
2
1
1
0
k
P D
k
D
k
D
V N
N N
+ + +
+
+ + =
P
N
= the expected sales price for the stock at time N
N = the specified number of years the stock is
expected to be held
Specified Holding Period Model
V
E
k
PVGO
PVGO
D g
k g
E
k
o
o
= +
=
+

1
1 1 ( )
( )
PVGO = Present Value of Growth
Opportunities
E
1
= Earnings Per Share for period 1
Growth & No Growth Components of
Value
ROE = 20% d = 60% b = 40%

E
1
= Rs. 5.00 D
1
= Rs. 3.00 k = 15%

g = .20 x .40 = .08 or 8%
Partitioning Value: Example
Partitioning Value: Example
Vo = 3/(0.15 0.08) = Rs. 42.86

NGVo = 5/0.15 = Rs. 33.33
(No Growth Value)

PVGo = Rs. 42.86 33.33 = Rs. 9.52
(Present value of Growth Opportunities)
P/E Ratios are a function of two factors
Required Rates of Return (k)
Expected growth in Dividends
Uses
Relative valuation
Extensive Use in industry
Price Earnings Ratios
P
E
k
P
E k
0
1
0
1
1
=
=
E
1
- expected earnings for next year
E
1
is equal to D
1
under no growth
k - required rate of return
P/E Ratio: No Expected Growth
) (
1
) (
) 1 (
1
0
1 1
0
ROE b k
b
E
P
ROE b k
b E
g k
D
P

=
b = retention ratio
ROE = Return on Equity
P/E Ratio with Constant Growth
E
0
= Rs. 2.50 g = 0 k = 12.5%

P
0
= D/k = Rs. 2.50/.125 = Rs. 20.00

PE = 1/k = 1/.125 = 8
Numerical Example: No Growth
b = 60% ROE = 15% (1-b) = 40%
E
1
= Rs. 2.50 (1 + (.6)(.15)) = Rs. 2.73
D
1
= Rs. 2.73 (1-.6) = Rs. 1.09
k = 12.5% g = 9%
P
0
= 1.09/(.125-.09) = Rs. 31.14
PE = 31.14/2.73 = 11.4
PE = (1 - .60) / (.125 - .09) = 11.4
Numerical Example with Growth
Pitfalls in P/E Analysis
Use of accounting earnings
Historical costs
May not reflect economic earnings
Reported earnings fluctuate around the
business cycle.
Other Valuation Ratios
Price-to-Book

Price-to-Cash Flow

Price-to-Sales
Inflation and Equity Valuation
Inflation has an impact on equity
valuations.
Historical costs underestimate economic
costs.
Empirical research shows that inflation has
an adverse effect on equity values.
Research shows that real rates of return are
lower with high rates of inflation.
Lower Equity Values with Inflation
Shocks cause expectation of lower earnings by
market participants.
Returns are viewed as being riskier with higher
rates of inflation.
Real dividends are lower because of taxes.
Bonds
Face or par value
Coupon rate
Zero coupon bond
Compounding and payments
Accrued Interest
Indenture
Bond Characteristics
Different Issuers of Bonds
Treasury
Notes and Bonds
Corporations
Municipalities
International Governments and Corporations
Innovative Bonds
Indexed Bonds
Floaters and Inverse Floaters
Secured or unsecured
Call provision
Convertible provision
Put provision (putable bonds)
Floating rate bonds
Sinking funds
Provisions of Bonds
) 1 (
) 1 (
1 r
ParValue
r
C
P
T
T
T
t
t
t
B
+
+
+ =

=
P
B
= Price of the bond
C
t
= interest or coupon payments
T = number of periods to maturity
r = semi-annual discount rate or the semi-annual
yield to maturity
Bond Pricing
C
t
= 40 (SA)
P = 1000
T = 20 periods
r = 3% (SA)



Price: 10-yr, 8% Coupon, Face = Rs.1,000
( )
77 . 148 , 1 .
) 03 . 1 (
1000
03 . 1
1
40
20
20
1
Rs P
P
t
t
=
+ =

=
Investment related websites
www.myiris.com
www.moneycontrol.com
www.indiainfoline.com
www.valuenotes.com
www.karvy.com
www.siainvestor.com
www.sebi.gov.in
www.amfiindia.com
www.freddiemac.com
www.sharekhan.com
www.motilaloswal.com
www.capitalmarket.com
www.trendwatch.com
www.nsdl.co.in
www.stcionline.com
www.icicidirect.com
www.bseindia.com
www.nse-india.com
Investment related websites cont
www.capitalideasonline.com
www.centraldepository.com
www.bondmarkets.com
www.bonds-online.com
www.debtonnet.com
Prices and Yields (required rates of return)
have an inverse relationship
When yields get very high the value of the
bond will be very low.
When yields approach zero, the value of
the bond approaches the sum of the cash
flows.
Bond Prices and Yields
Price
Yield
Prices and Coupon Rates
Yield to Maturity
Interest rate that makes the present value of
the bonds payments equal to its price.
Solve the bond formula for r

) 1 (
) 1 (
1 r
ParValue
r
C
P
T
T
T
t
t
t
B
+
+
+ =

=
Yield to Maturity Example
) 1 (
1000
) 1 (
35
950
20
1
r
r
T
t
t
+
+
+ =

=
10 yr Maturity Coupon Rate = 7%
Price = Rs.950
Solve for r = semiannual rate
r = 3.8635%
Yield Measures
Bond Equivalent Yield
7.72% = 3.86% x 2
Effective Annual Yield
(1.0386)
2
- 1 = 7.88%
Current Yield
Annual Interest / Market Price
Rs.70 / Rs.950 = 7.37 %
Realized Yield versus YTM
Reinvestment Assumptions
Holding Period Return
Changes in rates affects returns
Reinvestment of coupon payments
Change in price of the bond

Holding-Period Return: Single Period
HPR = [ I + ( P
0
- P
1
)] / P
0
where
I = interest payment
P
1
= price in one period
P
0
= purchase price

Holding-Period Example
CR = 8% YTM = 8% N=10 years
Semiannual Compounding P
0
= Rs.1000
In six months the rate falls to 7%
P
1
= Rs.1068.55
HPR = [40 + ( 1068.55 - 1000)] / 1000
HPR = 10.85% (semiannual)
Holding-Period Return: Multiperiod
Requires actual calculation of
reinvestment income
Solve for the Internal Rate of Return using
the following:
Future Value: sales price + future value of
coupons
Investment: purchase price

Rating companies
Moodys Investor Service
Standard & Poors
Duff and Phelps
Fitch
Rating Categories
Investment grade
Speculative grade
Default Risk and Ratings
Coverage ratios
Leverage ratios
Liquidity ratios
Profitability ratios
Cash flow to debt
Factors Used by Rating Companies
Sinking funds
Subordination of future debt
Dividend restrictions
Collateral
Protection Against Default
Default Risk and Yield
Risk structure of interest rates
Default premiums
Yields compared to ratings
Yield spreads over business cycles
Bonds recap
Reasons for issue
Reduce cost of capital
Leverage
Tax saving
Widen sources of funds
Preserve control
Bonds recap
Attributes
Length of time until maturity
Coupon rate
Call provision premature redemption above par
Tax status deep discount bonds
Marketability / liquidity
Likelihood of default risk premium
Y
T
M
{
Bonds - recap
Current yield = Annual interest / Market price
Holding period yield = (r + P) / Po
YTM yield, purchase to maturity
PV of all cash flows
Approx YTM = Int Discount / Premium
(Current price + Par value)/2
Bonds recap
Risks in bonds
Purchasing power
Interest rate
Price
Time period volatility
Coupon rate volatility
Yield volatility
Reinvestment
Bonds recap
Term structure
Structure of yields observed for bonds with
different terms to maturity (but no other difference)
ST r fluctuates more
LT P fluctuates more
Bonds recap
Term structure arises due to
Expectation hypothesis
1 year bond 6%, 2 years bond 7%
If investor believes that r will go up to 8%, he will buy
only 1 year bond
Liquidity premium hypothesis
LT more risk, more premium expected
Segmented market hypothesis
Different groups prefer different bonds
LIC LT
Banks ST
Examples
What is the YTM for a 12%, 15 year bond
selling at Rs.120 and par value of Rs. 100
What will be the YTM in the above case if the
bond was issued at a discount of 20%
Find the current yield, YTM & YTC for a 16%,
20 years bond callable after 10 years at Rs.
116. The selling price is Rs. 125 and par
value is Rs. 100.
Examples
What will be the price of a 12%, 15 year bond
with an YTM of 10%?
Find the price of a Zero coupon, 15 year
bond with YTM of 8 %. The par value is Rs.
1000
Find out
Duration
Immunization
Passive strategy
Bond ladder strategy
Derivatives
Options
Rights
Warrants
Futures


Terminology
Options agreement
Contract
Writer grants right to sell/buy
Designated instrument
Exercise price / strike price / striking price
Specified time period
Option premium
Call option right to purchase
Put option right to sell
Profit / Loss
Value at expiration
Stock price ~ Exercise Price

Profit
Final value ~ Original investment
American & European Options
American option
Holder exercises the right to purchase / sell the
underlying asset on or before the expiration
More valuable
NSE
European option
Holder can exercise the right only on the
expiration date
S&P Nifty
Listed options
Stocks
Foreign currency
Agro products
Gold
Silver
Fixed income securities

Option value determining factors
Effect of increase
Put Call
Current stock price (S)

Striking price (K)

Time to expiration (t)

Volatility

Interest rates

Cash dividends

Find the equivalents of
Long put
Long stock
Long call
Short call
Short stock
Short put
Positions & Strategies
Buy short-term securities
Buy stock
Sell stock short
Purchase a put
Buy a call
Write a call
Purchase the stock and sell a call
Sell a put
Call option value
Option
value
X
Stock Price
Value of Call
Intrinsic Value
Time value
Find out
Straddle
Strip
Spread
Strap
In-the-money contract
At-the money contract
Out-of-the-money contract
Contango
Backwardation
Black-Scholes Option Valuation
Pc = [Ps] [N(d1)] [Pe] [antiln (-Rf t)][Nd2]

Pc = market value of the call option
Ps = price of the stock
Pe = striking price of the option
Rf = annualized interest rate
Antiln = antilog (base e)
T = time to expiration in years
d1 = ln (Ps/Pe) + (Rf + 0.5o
2
) t / t

d2 = d1 - o t

Example
Ps = 54.38
Pe = 55
T = 0.5416
Rf= 3%
o = 19

Right
Option with very short life
Originate in new issue
Right given to current shareholders

Warrant
Call option
Longer shelf life

Trade Statistics for NSE
Trade Statistics for 13-Jul-2009
Product
No. of
contracts
Turnover
(Rs. cr.) *
Index Futures 6,60,362 12,516.99
Stock Futures 4,90,381 12,281.38
Index Options 11,78,647 24,287.94
Stock Options 43438 1,212.19
Interest Futures 0 0
F&O Total 23,72,828 50,298.51

Modern Portfolio Theories
Portfolio Theory
CAPM & APT
CML
SML
Efficient Market Hypothesis
Random Walk
Forms of efficiency
All information / Public information / No relation
Behavioural Finance
CAPM
Risk is measure by variance of expected
returns
Return = R.F. + Beta (MR RF)
The unsystematic risk is taken care of
diversification (SML)
Beta < 1 defensive securities
Beta > 1 aggressive scrips
CAPM
Empirical tests have not given support to the
theory
Many non-Beta factors also affect the returns
Calculation of Beta is itself doubtful, because
historical Beta may not reflect the future risk
or return
It also assumes that market is in equilibrium
Arbitrage Pricing Theory
Equilibrium model similar to CAPM
Investors do not look at expected returns and
SD
If price of an asset is different in different
markets, arbitrage brings them to the same
price
APT is based on the return generated by
factor models
APT
Pure factor portfolios depend on only one
factor
But in practice only impure factor portfolios
can be created
Synthesis of CAPM and APT is more realistic
Beta = Cov (Ri Rm) / Market variance
Portfolio Management
Sharpes measure
SI = (Avg Return RF) / SD total risk
Treynors Measure
TI = (Portfolio return RF) / Beta systematic risk
Jensens Model
Avg return RF = Alpha + Beta (MF RF)