Valuation of Securities15th February 2020
Security valuation is important to decide on the portfolio of an investor. All investment decisions are to be made on a scientific analysis of the right price of a share. Hence, an understanding of the valuation of securities is essential. Investors should buy underpriced shares and sell overpriced shares. Share pricing is thus an important aspect of trading. Conceptually, four types of valuation models are discernible.
(i) Book value,
(ii) Liquidating value,
(iii) Intrinsic value,
(iv) Replacement value as compared to market price.
(i) Book Value:
Book value of a security is an accounting concept. The book value of an equity share is equal to the net worth of the firm divided by the number of equity shares, where the net worth is equal to equity capital plus free reserves. The market value may fluctuate around the book value but may be higher if the future prospects are good.
(ii) Liquidating Value (Breakdown Value):
If the assets are valued at their breakdown value in the market and take net fixed assets plus current assets minus current liabilities as if the company is liquidated, then divide this by the number of shares, the resultant value is the liquidating value per share. This is also an accounting concept.
(iii) Intrinsic Value:
Market value of a security is the price at which the security is traded in the market and it is generally hovering around its intrinsic value. There are different schools of thought regarding the relationship of intrinsic value to the market price. Market prices are those which rule in the market, resulting from the demand and supply forces. Intrinsic price is the true value of the share, which depends on its earning capacity and its true worth. According to the fundamentalist approach to security valuation, the value of the security must be equal to the discounted value of the future income stream. The investor buys the securities when the market price is below this value.
Thus, for fundamentalists, earnings and dividends are the essential ingredients in determining the market value of a security. The discount rate used in such present value calculations is known as the required rate or return. Using this discount rate all future earnings are discounted back to the present to determine the intrinsic value.
According to the technical school, the price of a security is determined by the market demand and supply and it has very little to do with intrinsic values. The price movements follow certain trends for varying periods of time. Changes in trend represent the shifts in demand and supply which are predictable. The present trends are the offshoot of the past and history repeats itself according to this school.
According to efficient market hypothesis, in a fairly large security market where competitive conditions prevail, market prices are good proxies for intrinsic values. The security prices are determined after absorbing all the information available to market participants. A share is thus generally worth whatever it is selling for in the market.
Generally, fundamental school is the basis for security valuation and many models are in use, based on these tenets.
(iv) Replacement Value:
When the company is liquidated and its assets are to be replaced by new ones, their prices being higher, the replacement value of a share will be different from the Breakdown value. Some analysts take this replacement value to compare with the market price.
Factors Influencing Security Valuation:
Security price depends on a host of factors like earnings per share, prospects of expansion, future earnings potential, possible issue of bonus or rights shares, etc. Some demand for a particular stock may give pleasure of power as a shareholder or prestige and control on management. Satisfaction and pleasure in the non-monetary sense cannot be considered in any practical and quantifiable sense. Many psychological and emotional factors influence the demand for a share.
In money terms, the return to a security on which its value depends consists of two components:
(i) Regular dividends or interest, and
(ii) Capital gains or losses in the form of changes in the capital value of the asset.
If the risk is high, return should also be high. Risk here refers to uncertainty of receipt of principal and interest or dividend and variability of this return.
The above returns are in terms of money received over a period of years. But money of Re. 1 received today is not the-same as money of Re. 1 received a year hence or two years hence etc. Money has time value, which suggests that earlier receipts are more desirable and valuable than later receipts. One reason for this is that earlier receipts can be reinvested and more receipts can be got than before. Here the principle operating is compound interest.
Thus, if Vn is the terminal value at the period n, P is the initial value, g is rate of compounding or return, n is the number of compounding periods, then Vn = P (1 + g)n.
If we reverse the process, the present value (P) can be thought of as reversing the compounding of values. This is discounting of the future values to the present day, represented by the formula-
P = Vn /(1+ g)n
Graham’s Approach to Valuation of Equity:
In their book on Security Analysis (1934) Benjamin Graham, and David Dodd, argued that future earnings power was the most important determinant of the value of stock. The original approach of identifying the undervalued stock is to find out the present value of forecasted dividends, and if the current market price is lower, it is undervalued. Alternatively, the analyst could determine the discount rate that makes the present value of the forecasted dividends equal to the current market price of the stock. If that rate (I.R.R. or discount rate) is more than the required rate for stocks of similar risks, then the stock is underpriced.
Graham and Dodd had argued that each dollar of dividends is worth four times as much as one dollar of retained earnings (in their original Book); but subsequent studies of data showed no justification for this. Graham and Rea have given some questions on Rewards and risks for financial data analysts to answer yes or no and on the basis of these ready to answer questions, they decided to locate undervalued stocks to buy and overvalued stocks to sell.
Such readymade formulas or questions are now out of favour due to various empirical studies which showed that earnings models are as good as or better than dividend models and that a number of factors are ably studied for common stock valuation and no unique formula or answer is justifiable.
Securities Valuation in India:
In India, the valuation of securities used to be done by the CCI for the purpose of fixing up the premium on new issues of existing companies. These guidelines used by CCI were applicable upto May 1992, when the CCI was abolished. Although the present market price will be taken into account a more rational price used to be worked out by the CCI on certain criteria.
Thus, the CCI used the concept of Net Asset Value (NAV) and Profit-Earning Capacity Value (PECV) as the basis for fixing up the premium on shares. The NAV is calculated by dividing the net worth by the number of equity shares. The net worth includes equity capital plus free reserves and surplus less contingent liabilities.