Security Valuation – Quick Revision Notes

Overview of Valuation

• Investment = commitment of funds to earn returns compensating for time, inflation & risk.
• Intrinsic value estimation is key for: portfolio selection, M&A pricing, corporate finance decisions.
• Same core valuation principles apply to all asset types; difficulty & uncertainty differ.

Return Concepts

• Required Rate of Return (RRR): minimum acceptable return; equals opportunity cost (cost of capital).
• Discount Rate: rate converting future cash flows to present value; reflects \text{Risk-free rate + Risk premium}.
• Internal Rate of Return (IRR): discount rate that sets PV of future cash flows = initial outlay; assumes reinvestment at IRR.

Equity Risk Premium (ERP)

• ERP = excess equity return over risk-free rate; compensates for higher equity risk.
• Estimated via historical differences or CAPM: \text{ERP}=\betax\,(Rm - R_f) (when using stock-specific beta).

Required Return on Equity (CAPM)

• Formula: Ke = Rf + \beta\,(Rm - Rf).
• Example: Rf=5\%,\;\beta=1.5,\; (Rm-Rf)=4.5\% \Rightarrow Ke=11.75\%.

Discount Rate vs. Cash-Flow Type

• Nominal cash flow → nominal discount rate.
• Real cash flow (inflation-adjusted) → real discount rate.
• Equity valuation uses nominal post-tax cash flows and nominal K_e.
• Valuing all-stakeholder flows requires WACC.

Valuation of Equity Shares

Dividend-Based Models

• One-year holding: P0=\dfrac{D1+P1}{1+Ke}.
• Zero-growth (perpetuity): P0=\dfrac{D}{Ke}.
• Constant-growth (Gordon): P0=\dfrac{D1}{K_e-g}.
• Two-stage / three-stage & H-model handle variable growth.

Earnings-Based Models

• Gordon’s Earnings model: P0 = \dfrac{\text{EPS}(1-b)}{Ke - br}.
• Walter’s model: P0 = \dfrac{D + (E-D)\,r/Ke}{K_e}.
• P/E approach: P = \text{EPS}\times \text{Industry P/E}.

Cash-Flow-Based Models

• FCFF (discount at WACC) values firm; FCFE (discount at K_e) values equity.
• FCFF formula (EBIT basis): FCFF = EBIT\,(1-t)+Dep - \text{CAPEX} - \Delta NWC.
• Intrinsic value (one-stage): PV of stable-period FCFF; two-stage and three-stage add explicit & transition phases.

Rights Valuation

• Theoretical Ex-Right Price (TERP): \dfrac{nP0 + S}{n+n1}.
• Value of one right: TERP - \text{Subscription price}.

Valuation of Preference Shares

• Redeemable: PV of fixed dividends + redemption value, discounted at required pref. return.
• Irredeemable: P0 = \dfrac{D}{K{ps}}.

Valuation of Debentures / Bonds

• Bond price (annual): P=\sum_{t=1}^{n}\dfrac{I}{(1+k)^t}+\dfrac{F}{(1+k)^n}.
• Semi-annual: use half-year coupon, rate, periods.
• Price–yield rules: k = coupon → par; k > coupon → discount; k < coupon → premium.
• Duration (Macaulay): weighted average time of cash-flow recovery; modified duration = Macaulay /(1+y).
• Convexity adjusts duration for large yield changes.
• Immunisation: match duration to investment horizon to offset price & reinvestment risk.

Yield Curve & Forward Rates

• Spot rate curve: current zero-coupon yields by maturity.
• Forward rate extraction: e.g. f2 = \dfrac{(1+r2)^2}{(1+r_1)} -1.
• Term-structure theories: Expectations, Liquidity Preference, Preferred Habitat.

Special Bond Types

• Zero-Coupon Bonds: issued at deep discount; single maturity payment.
• Convertible bonds & warrants: value = straight bond + option (conversion ratio × share price).
• Bond refunding: compare NPV of interest savings vs. costs (call premium, new issue costs).

Money Market Instruments (Brief)

• Call/Notice Money: overnight to 14-day inter-bank loans.
• Treasury Bills: 91/182/364-day Govt. discount papers; yield =\dfrac{F-P}{P}\times\dfrac{365}{M}.
• Commercial Bills: trade bills discounted by banks.
• Certificates of Deposit & Commercial Paper: short-term negotiable, issued at discount.
• Repo/Reverse Repo: collateralised borrowing/lending; repo rate (borrower), reverse-repo rate (lender/RBI).

Enterprise Value (EV) & Multiples

• EV = \text{Market Cap} + \text{Debt} + \text{Minority Interest} - \text{Cash & Investments}.
• Multiples: EV/Sales (for negative-earnings firms), EV/EBITDA (capital-intensive firms).

Valuers: Role & Responsibilities

• Statutory valuations for M&A, slump sale, debt conversion, strategic restructuring, etc.
• Must follow Companies (Registered Valuers & Valuation) Rules, 2017 Code: Integrity, competence, independence, confidentiality, proper records, avoid success fees, disclose conflicts.

Precautions Before Accepting an Assignment

• Understand business narrative & data quality; valuation is an estimate, not exact.
• Balance quantitative models with qualitative factors (growth potential, scalability).
• Beware of bias, emotion, “mandate snatching”, unrealistic precision.
• Ensure adequate time, data access, compliance, and independence before engagement.