Security Valuation: Meaning and Factors | Financial Economics

In this article we will discuss about:- 1. Meaning of Security Valuation 2. Factors Influencing Security Valuation 3. Graham’s Approach to Valuation of Equity 4. Securities Valuation in India.

Meaning of Security Valuation:

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.

They are:

(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

where the meaning of the terms used is the same as indicated above.

The major factor which influences security prices is the return on equity capital to the investor. This return may be in the form of dividends or net earnings of the company. Thus, the value of a share is a function of the company’s dividend paying capacity or its earnings capacity. The dividends may be different from the earnings depending on the amount of profits retained by the company for the requirements of liquidity, expansion, modernization, etc.

Normally, the value of a share is its book value, if the shares are not quoted on the market. On the other hand, the market price of shares quoted will differ from the book value based on investors’ perception of the future earning potential of the company, growth prospects and the industry prospects, quality of management, the goodwill or the intangibles of the company.

If the security is a bond or debenture and has a fixed return like 14% per annum, its market price depends upon investor’s perception of the capitalization rate which may be assumed to be 15%.

In this case-

If the security is an equity share, its return is Dividend + Capital appreciation. Then the future dividends may not be constant or fixed as also the degree, of capital appreciation.

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. The PECV is estimated by multiplying the earnings per share by a capitalisation rate of 15% for manufacturing companies, 20% for trading companies and 17.5% in the case of intermediate companies. Earnings Per Share (EPS) is calculated by dividing the three-year average post-tax profits by the total number of equity shares. Thus, if EPS is Rs. 5 and if the price earnings multiplier is 15, the price of share, which is reflected by the PECV, should be Rs. 5 x 15 = 75 (if it is a manufacturing company).

To be more specific,

The Net Asset Value of a company (NAV) = Total assets less liabilities, borrowings, debts, preference capital and contingent liabilities which is to be divided by the number of shares.

The (PECV) is obtained by capitalising the average profits after tax (over the past three years) by a rate varying from 15% to 20% depending on the nature of the activity of the company.

The fair value of the share is the average of the NAV and PECV. This Fair Value (FV) is taken into account for comparison with the average market price over the preceding three years and the average market price should be less than the fair value by at least 20%. If the average market price is 20% to 50% of the FV, the capitalisation rate to be used is 12%. If it is 50% to 75% of the FV, the capitalisation rate is 10% and if it is more than 75% of FV, the capitalisation rate is 8%.

Example:

This example will make the above exercise clear (year 1990).

Take a manufacturing company (TISCO)

Average Market Price over the last three years = Rs. 123

Net Asset Value (NAV) computed as shown above = Rs. 68

Profit-Earning Capacity Value (PECV) = Earnings per share Rs. 5.4

capitalised by 15% for manufacturing company = 5.4×100/15 = Rs. 36.

Average of NAV and PECV is (68 + 36)/2 = Rs. 52 which is the fair value.

The market price is more than 75% of the Fair Value (Rs. 52). Hence, the capitalisation rate of 8% is to be applied as referred to above to the earnings per share.

Earnings per share is Rs. 5.4.

At the capitalisation rate of 8%, the PECV = Rs. 67.50.

Book value per share or NAV is Rs. 68.

The average of the two above is Rs. 67.75.

For a share of Rs. 10 of face value, the premium is thus Rs. 57.75.

Since May 1992, with the repeal of C.I.C. Act, free market pricing of shares has been permitted. The price of new issue can be decided by the company and its Merchant banker. As per the existing guidelines of SEBI, the merchant banker need not submit the proposals regarding the share price, premium, if any, etc. of new issues to the SEBI for vetting, but the justification for the same is to be provided in the prospectus. A margin of 20% on either side is permitted to change the actual premium from the premium submitted to SEBI for record or vetting.