Valuation principles and practices Chapter 5

Outcome

• Explore the process to find the so-called fair value of an asset.

• Examine valuation concepts e.g. Par value, Market value, Book value and Fair value.
• Explore the required input variables for valuation purposes.
• Examine the valuation of financial securities.

5 2 .
Valuation concepts

Valuation:

• Fair value aka intrinsic value

• Importance of valuation – compare fair value with market value:

Fair value > market value – Buy (undervalued)
Fair value < market value – Sell (overvalued)

• Par value (Face value) & (primary market pg. 24)

• Market value & (secondary market pg. 24 +25)

Market value added & market capitalisation

• Book value….
Fixed assets: the cost of buying and installing these assets minus accumulated depreciation
Ordinary shares: par value per share x the number of shares issued, + cumulative retained
earnings, + capital contributed in excess of par

Fair (intrinsic) value

• The present value of all future cash flows the asset is expected to generate from an asset
• GENERIC valuation Formula:

value

Where:
• CFt = net cash flow from asset
• k = required rate of return

(cost of equity/capital – estimated with CAPM)

 .3
5 Required input variables for valuation processes

1. Cash flows (returns) (PMT)

2. Timing N)
3. Discount rate (also the required rate of return/cost of capital)
(IY)
• The discount rate should reflect the risk-return relationship of the asset concerned
• Lower risk = more certain cash flows; lower value
• In terms of time value:
Lower risk = lower discount rate to determine PV
Higher risk = higher discount rate to determine PV

Growth rate (g) = ROE x retention rate

= ROE x (1 - payout ratio)

.
5 4 Valuation of financial securities

Bond valuation

Basic background
• Companies issue bonds (bond issuer) to the public/investors (bondholder) as one of their forms of
long-term debt financing. I.e. companies need capital(borrower) from investors (lenders) to expand
their company and operations.
• Bonds are fixed-income securities since they impose fixed financial obligations on the issuer
(company).
• Maturities 10-20 years
• Bond issuer pays fixed amount of Interest. Interest is paid semi-annually (6 months) to the
holder, but principal repaid @end of loan(maturity)
• Interest payments = bond's coupons

Bond valuation: Example: pg. 69

• Bonds issued at par value of R 1000 each.
• Semi annual coupons payment for 10 years.
• RR = CP rate of i = 14%.

( X
i
X

X
 By means of a financial calculator (use
previous example – pg. 69)

Add together:
Market Value of Bond
741.580997 + 258.419003 = 1000

Yield to maturity (YTM)

• Rate of return earned if bond is bought at specific price and held until maturity

Example 1: - Pg. 70
Capitec Bank has issued bonds at R1000 000 each. A bond currently trades at R1 100 000 and
has 5 years to maturity. Interest is paid at R 112 500 per annum. What is the YTM?

1000000 1000000 1100000 See error on page 67

1100,000
-
-

112500 + : Answer of approximate YTM

5 2
is incorrect (must be 8.81%)

= 112 500 + (-20 000) 1 050 000 I 112 500

= 92 500 / 1 050 000 M 1000000

= 8.81% DBo 1 100 000

M 5

Example 2:
SAB bond issued at R1000, currently trades at R840, 10 years to maturity, coupon paid annually at
15%. What is the YTM?

= [150+((1000-840)/10)] /( (1000+840)/2)
= (150+16) / 920
= 18.04%
Bond value, Required return & time to maturity
Bond value – varies over its lifetime

Whenever the required return ≠ coupon rate, the bond value ≠ par value

If the RR > CR, the bond value < than its par value. (discount or premium)?
If the RR< CR, the bond value > par value. (discount or premium)?

RR CP Investor will do better with market's i RR ,

because
6 % 5% it's higher than the bond's coupon i

Bond V Par V
-

RIOO R 150 CP
P =
1 + ra MR RR :

trade discount

Bond Price
If i to 5 %, the CP of 5 %

Po
is no
longer attractive ,
thus
P,
bond price Demand decreased
D
on bonds

RR CP Investor's CPi of bond is higher than

4% 5% market RR
B value Par V
CP
R150 RIOG P =
1 + r" MR RR :

Trade premium

Bond Price If i to 4 %, the CP of 5%

is more attractive than market i,

P,
thus bond price demand for
Po
bonds increases
D

..
If the RR > CR, the bond value < than its par value - discount
..
If the RR < CR, the bond value > par value - premium
 Time to maturity

• If the required return is different from the

coupon interest rate, the length of time to
maturity affects the bond value
• The shorter the time to maturity, the less
responsive its market value is to changes in
the market

Preference share valuation

Features:

• Are second in line to receive capital repayments after debt holders if the company is wound up.
• Receive a higher level of income than debt holders because of the higher risk involved. Preference
shareholders are not guaranteed dividend payments in the way that debt holders are guaranteed
interest payments.
• Have a better chance of receiving dividends than Ordinary shareholders, although Preference
shareholders are not guaranteed dividend payments.
• Preference shareholders are guaranteed specified percentage dividends if the company makes a
profit.
• Preference shareholders do not have right to vote at annual general meetings.
• Preference shares carry a higher risk than debt instruments, but lower risk than Ordinary Shares.

Formula
where : vP value of preference share

Dp-dividend preference
of
-

required rate of return

Example – pg. 71: Woolworths Ldt. issues 6% preference shares @100 cents each (dividend
therefore 6 cents per share (0.06 x 100cents). Required rate of return = 3.5%

What is the fair value of the preference share?

Vp = 0.06 cents / 0.035 (required rate of return)

Vp = 171 cents or R1,71

Investor should consider buying share if it market price trades at a price BELOW fair value of 171 cents

Example 1: 160 cents (market value) < 171cents (fair value) = undervalued; buy
Example 2: 180 cents (market value) > 171 cents (fair value) = overvalued; sell
 Valuation of ordinary shares

• The valuation of ordinary shares can be done in two ways, discounted cash flow techniques
OR relative valuation
• Discounted cash flow techniques:
1. constant growth model,
2. two-stage dividend discount model, the
3. three-stage dividend discount model (DDM)
4. No-growth model

1. Calculation of Constant growth or DDM or Gordon Growth model (pg 72 6th ed.):

where : DP3
,= dividends/share expected in 1 year
k = required rate of return
g = constant annual growth rate

Example pg. 72:

Sasol Ltd is expected to pay dividend of R3.20 next year. Growth rate of firm is 17.2% and investors
RRR is 20%. What is the value of the share?

= 3.20 (dividend per share) /(0.2-0.172) (required return – growth rate)

= R114.28

Investor could consider buying share if it trades below R114.28

Limitations of DDM
• It is only valid for firms that grow at a constant rate of return
• As the growth rate (g) converges with the discount rate (k) the value goes to infinity.
• If the growth rate exceeds the required rate of return, the value of the share cannot
be determined

The DDM is a good valuation tool for firms that has the following features:
• Stable earnings growth rate at or below the nominal growth rate in the economy
• A well established dividend payout policy that is likely to continue into the future
• A payout ratio that is consistent with the assumption of stability
• Stable leverage and beta
 2. Two-stage dividend discount model (2-stage DDM)

2 stages:
1. initial phase (extraordinary growth)
2. second phase of steady state stable growth

For an initial phase of n-years, the DDM can be represented as:

Where :

Value of share DPS = dividend/share expected in period t

t

k = required rate of return

Pn = share price at the end of the year n
See DDM examples (selfmade)
& DDM Example pg 73_1-1

4. No growth model - pg. 75

Value of firm where :

E = perpetual stream of earnings (EPS)
k = required rate of return

Example – pg 75
Illovo Ltd maintains earnings per share @84 cents. RRR 9.8%.
What is the fair (intrinsic) value?

Value of firm 857 cents

the investor should buy the share if it trades below R8.57

Measures of
relative value

• Used to rank shares of

similar firms from the
same sector
 aluation of investment trusts

Investment trusts pool funds of investors who have bought shares in the trust and invest
these funds in various assets
• Net asset value (NAV) formula:

• Measures the market value of an investment company’s assets :

• NAV can be used to assess whether a share is over- or undervalued

Example pg. (Not in textbook)

• Assume Alliance Trust issues 143 380 ordinary shares, shares are trading @ R10 each.
The firm's total assets = R2800 000, and total liabilities = R850 000. Assume other
companies similar to Alliance Trust trade @ discount of 20% to NAV. Calculate the NAV.

• NAV is R 13.60, the Alliance Trust shares are at a discount of 26.47% ((13.60-10)/13.60).
• If company trades at R10/shares and at a discount of 20% to related shares: R13.60*0.8 = R10.88,
thus share is undervalued.
What a discount may indicate?

Example 1:
• NAV = R13.60 (value of share)
• Currently trades at R10.00 13 6-10
.

• 20% is regarded as a norm but shares are trading at discount of 26.41% 13 6

.

• To trade at 20% : 13.6 - (13.6 x 20%)

13.6 – 2.72
R10.88 (must trade)

• So the share is currently trading at R10, but is worth R10.88.

• The share is undervalued.
• BUY!
Example continue… (Alliance Trust)

• NAV = 8.70
• But trades currently at R10 each (market value)
• Shares are at discount of 14.94% (R8.70 – R10/ 8.70)
• 20% discount is regarded as the norm/benchmark
• To trade at 20% discount, it must trade at R6.96 (R8.70 x 0.2 ) = R1.74 and (R8.70 – R1.74) =
R6.96 (fair value)
• Share is currently trading at R10 each (market value) but worth R6.96(fair value). Share is
overvalued, don’t buy.

Self evaluation

• Explain the following valuation concepts: Par value, Market value, Book value and Fair value.
• Discuss the required input variables for valuation purposes.
• Discuss the valuation of the following financial securities:
·

Bond valuation
Preference shares
/

Ordinary shares
/

Investment trusts
-
 DDM VRAE DDM Dividend Discount model

I .
Assume a company’s most recent dividend was 15 cents per share. The dividends are expected
to increase by 12% annually over the next 3 years. At the end of the 3 years, the growth
rate is expected to drop an 11% annual growth rate for 2 years. The growth rate after thr
first 5 years is then expected to remain constant at the 10% per annum, ad infinitum. The
firm’s required rate of return is 15%
3-stage

.
2 Assume Sasol’s most recent dividend was 15 cents per share. Dividends are expected to increase
by 12% p.a. for 3 years. After 3 years, the growth rate drops to 10% p.a. indefinitely.
Required rate of return = 15%
2-stage

. The following information regarding the dividends of a share is forecasted:

3

2-stage
• Do = R5 per share.
• Expected dividend growth for the next three years is 12%.
• Thereafter a constant growth of 8% is expected, ad infinitum.
• The shareholders' required rate of return is 15%.
• The current share price is R87.

Calculate the intrinsic value of the share and indicate if the share under- or overvalued.

4 The following information regarding the dividends of British American Tobacco PIc's share is forecasted:

• Assume British American Tobacco Plc's most recent dividend (D.) was R7.30 per share.
• Dividends are expected to grow by 14.86% annually over the next two years.
• At the end of the two years, the growth rate is expected to decline linearly for four years until
a 6.20% annual growth rate is reached.
• At the end of year six, it is expected that the growth rate will remain constant at 5.50% (per
year) ad infinitum.
• The firm's cost of capital is 8.85%. 3-stage
• Calculate the fair (intrinsic) value of the share.
 I .

3-Stage DDM
Assume a company’s most recent dividend was 15 cents per share. The dividends are expected to
increase by 12% annually over the next 3 years. At the end of the 3 years, the growth rate is
expected to drop an 11% annual growth rate for 2 years. The growth rate after thr first 5 years
is then expected to remain constant at the 10% per annum, ad infinitum. The firm’s required rate
of return is 15%
10 %
infinitum

we
s
12 % 12 % 12 %
11 % 11 %

Step 1 : Calculate future cash flows

Bo 15 Fr PV 1 + in
Di 15 1 12
.
16 S
.
Phase I

D2 16 .
8 1 12
.
18 816
.

D3 18 816.
1 12
.
21 .
07392
Phase
D4 21 07392
.
1 1
.
23 39205/.
2

D5 23 392051 . 1. 25 965177.
571 . 23388 597 199057 .

Bo 25 .
965177 1 18 .
28 561694.

Step 2 : Constant growth rate

DPS , 28 561694
571 23388
.

k
.

g 0 15 0 10
-

.
.

mi
decimal form

Step 3 : Calculator
Scenario I

O ENT Current market value R2 .

00

16 S ENT R2 00 vs R3 53
Growth
. . .

18 816 .
ENT
Buy undervalued potential

21 .
07392 ENT 3 52 98. cent

23 39205/ ENT Scenario 2

Rj53
.

597 199057 .
ENT Current market value R5 .
52

2nd F ~
(Fi R552 vs R3 53
rowth
- .

15 -

ENT Don't buy overvalued Noential

Comp
-
2 .
2-Stage DDM
Assume Sasol’s most recent dividend was 15 cents per share. Dividends are expected to increase
by 12% p.a. for 3 years. After 3 years, the growth rate drops to 10% p.a. indefinitely.
Required rate of return = 15%

%
Yo Yz
YI Y3
indefinitely
wh
12 % 12 % 12 %

Step 1 : Calculate future cash flows

Bo 15 Fr PV 1 + in
Di 15 1 12
.
16 S
.

D2 16 .
8 1 12
.
18 816
.

D3 18 816
.
1 12
.
21 .
07392 + 463 62624
. 84 .
70016

D4 21 07392 .
1 10
. 23 181312
.

Step 2 : Constant growth rate

DPS , 23 181312
463 62624
.

k
.

g . 15-0 10
0
-

RRR Constant
annual
growth
rate

Step 3 : Calculator

O ENT

16 S .
ENT

3
18 816
.
ENT 347 53 .
cent

84 .
70016 ENT Fair value of Sasol's share
2nd F ~
(Fi R3 48 %
15 -

ENT

Comp
-
.
3

The following information regarding the dividends of a share is forecasted:

• Do = R5 per share.
• Expected dividend growth for the next three years is 12%.
• Thereafter a constant growth of 8% is expected, ad infinitum.
• The shareholders' required rate of return is 15%.
• The current share price is R87.

Calculate the intrinsic value of the share and indicate if the share under- or overvalued.

8%
Yo YI Yz Y3

-
12 % 12 % 12 %

Step 1 : Calculate future cash flows

FV = PV 1 + in
Do
Di R 1 12
.
5 6 .

D2 56 . 1 12
.
6
. 272

Da 6 272 .
1 12.
7 02464
.
108 38016
. 115 .
4048
D4 7 02464
.
1 08
.
7 586611.

Step 2 : Constant growth rate

DPS
, 7 586611
108 38016
.

k 0 15-0 08
g
-

.
.

Step 3 : Calculator

g ENT

5 6
.
ENT

6
. 272 ENT

115 .
4048 ENT

2nd F -
CF ;
15 ENT 85 49 Don't
buy overvalued
- :
.

Comp Because the current share price is 82

 4.

The following information regarding the dividends of British American Tobacco PIc's share is forecasted:

• Assume British American Tobacco Plc's most recent dividend (D.) was R7.30 per share.
• Dividends are expected to grow by 14.86% annually over the next two years.
• At the end of the two years, the growth rate is expected to decline linearly for four years until
a 6.20% annual growth rate is reached.
• At the end of year six, it is expected that the growth rate will remain constant at 5.50% (per
year) ad infinitum.
RRR
• The firm's cost of capital is 8.85%.
• Calculate the fair (intrinsic) value of the share.

165 165 165 165

Yo
2 2
2 2

Y4
- .

Yo
- .

Yi
.
- .

Y3
-

YI Y2

a
nic
14 86 %
.
14 86 % . 14 86
.
2 165 %
.
12 . 6952 165 % . 10 53 2 165 %
. .
8 3652
.
. 165 %
12 . 695 =
10 53 .
= 8 365 .
-
.2
6

Step 1 : Calculate future cash flows Secline linearly 14 86 .

-

6 2 .

8 66.
= 4
Do R1 .
3 2 . 165 %
Di 7 3 .
1 1486
.
8 38478
.

Stage I

D2 8 384781 1486 9
. 630758
in
. .

Da 9
. 630758 1 12695
.
10 .
853383 Fr PV 1 +

D4 10 .
8533831 .
1053) = 11 996244
.

Stage 2

995 +
434 776925 .
448 582638 .

Step 2 : Constant growth rate

DPS 14 565027
434 776925
, .

k
.

g 0 0885 .
-

0 055.

Step 3 : Calculator

8 ENT 2nd F ~
(Fi
8 38478 .
ENT . 85
8
-

ENT

9
. 630758 Comp
-

ENT

10 .
853383 ENT

11 996244
.
ENT =
R310 . 99
12 999730 .
ENT

448 582638 .
ENT
 HW 2-rang 6 DDM

Kumba Iron Ore Ltd's most recent dividend was R9.60 per share. Assuming a high growth rate for
the next three years at 13% per year and a stable growth of 5% per year thereafter (ad infinitum),
calculate the company's fair value. Assume the shareholders required rate of return is 11%.

5%

13 % 13 % 13 %

Do R9 .
6

Di 9 6 .
1 .
13 =
10 . 845

D2 10 848
.
1 .
13 =
12 .

25824

D3 12 25824.
1 .
13 =
13 . 851811 +
242 406696
,
= 256 .
258507

D4 851811(1 05)

5444029
13 . .
=
14 .

14 544402 .

=
242 406696
. 11
0 -0 05 .
,

O ENT

Calculator
10 . 845 ENT

12 .

25824 ENT

256 .
258507 ENT

2nd F CF ;

Il ENT = 207 .
096047
↓ Comp
 Bond market value, YTM
Calculate the market value of a bond if:

• Required rate of return = 7%

• Maturity = 3 years
• Coupon = 10% annually
• Par value = R 1 000 000

Calculate YTM:

Step 1. Calculate the Market Value

1000 000 + 10 : R100 000

① Future cash flows ②

100 000
PMT 1, 000 000 Fl
7 IY IY
7

3 N 3 N

? PV ? PV

262431 .
6044 816297 .
8769

262431 .
6044816297 .
8769

1078 729 .
48 Market value of the bond

YTM :
100 000 PMT

3 N

1000 000 Fu

PV Market value
+

1078729 48 .

Y IY

I/Y
 HW2-question) Bond Market Value

Distell Ltd issued a coupon bond with a par value of R890 000. The coupon bond pays an annual
interest rate of 10.20% (nominal) per year and matures in 10 years. Assume that an investor's required
rate of return is 12.00%. Determine the market value of the bond.

RR 12 %

Maturity 10
Coupon 10 2 %.

Par value 890 000

890000 x 10 2 %
.
=
90780

90780 PMT 898 000 Fu

10 N 10 N

12 I Y 12 -
TY
? Pf ? Pf

512927 . 2465 t 286556 .

1806

=
799483 . 43
 Unprepared test 2 question
• The firm's cost of capital is 21%.
• The current market price of the share is R11.04.
• Assume: Bogus Ltd's most recent dividend (Da) was R0.884 per share.
• Dividends are expected to grow by 26% annually over the next three years..
• At the end of the third year the growth rate is expected to decline linearly for four years until
an 10.00% annual growth rate is reached.
• At the end of year 7, it is expected that the growth rate will remain constant at 6.78% per
year ad infinitum.
• Calculate the fair (intrinsic) value of the share and determine whether the share Is over-or
undervalued. Use six decimals in calculations..

6 78 %
.

Yo Y7
>
YI Y2 Y3 Y4 Y5 Y6
I I
% 26 % 22
I
18-4
&
14 4
I

j4
26 % 26 26 4
-

22 , 14 10

26 -

10 = 16 =
4 =
4
Do 0 .

884
Di 0 .

884 1 26
.
=
1 .
113840

e
1 .
113840 1 26
.
=
1 .
403438
1 . 4034381 .
26 =
1 768332
.

1 768332.
22) 1 .
=
2 .
157366
. 157366(1 18)
2 .
= 2 . 545691
. 545691
2 (1 14
! 2 902088
=
.
.

2 902088/1 10 27
I
. .
3 .
192297 + 23 971411
.
=
.
163708
DS . 192297 (1 0678)
3 .
=
3 408735
.

3408735 - 23 97141/
.

0 21
.
-

0 0678 .

G ENT

1 .
113840 ENT

1 .
403438 ENT

1 768532.
ENT

2 .
157366 ENT
=
12 .

94
. 54569/
2 ENT

2 902088

27
.

163708
ENT

ENT
buy-undervaluedMP is undervalued
Market Price 11 04
.

. that's why you BUY

2nd F CFi
21 ENT

b
Comp
 Exam revision DDM answer

10 %
16 % 16 % 16 % 14 5.
13 11 5.
18

Do = 180

Di = 180 (1 16).
=
208 8 .

Dz =
208 8 (1 .
.
16) =
242 208 .

208(1 16)
D 242 280 96128
= =
. .
.

4
=
280 .
96128(1 145) .
=
321 .
700666
D5 -
321 700666.
(1 13) .
=
363 .
521752
Do =
363 521752 .
(1 115) .
=
405 326754
.

DT =
405 . 326754(1 1) .
=
445 859429 .
+ 12261 .
13429 =
12706 99372
.

#904453212261 .
134

6201 .
294735