Discuss the methods of valuation of variable income securities?

Discuss the methods of valuation of variable income securities?

The term variable-income security refers to investments that provide their owners with a rate of return that is dynamic and determined by market forces.  Variable-income securities provide investors with both greater risks as well as rewards.

Variable-income securities, also known as variable-rate securities, are typically valued by investors looking for higher returns than those offered by fixed-income securities.  The classic example of a variable-income security is common stock, which can offer investors virtually unlimited up-side growth as well as the complete loss of principal.  In exchange for this risk, investors in these securities demand higher returns than their fixed-income counterparts.  In addition to common stocks, examples of variable-income securities include:

Equity shares are floated in the market at face value, or at a premium or at a discount. Only companies with a track record or companies floated by other firms/companies with a track record are allowed to charge a premium. The premium is normally arrived at after detailed discussions with the merchant bankers. This is the first exercise involving the valuation of share by the company itself. After allotment of shares to the shareholders, the company may distribute its surplus profits as returns to investors. The returns to equity shareholders are in the form of distribution of business profits. This is termed as declaration of dividends. Dividends are declared only out of the profits of the company. Dividends are paid in the form of cash and are called cash dividends. When shares are issued additionally to the existing investors in the form of returns, they are called bonus shares. These decisions are taken in the annual general meeting of the shareholders. The announcement of dividend is followed by the book closure dates, when the register of shareholders maintained by the company is closed till the distribution of dividends. The shareholders whose names appear on the register on the date are entitled to receive the dividend payment. Cash dividend payments reduce the cash balance of the company while bonus share payments reduce the reserve position of the company. Thus, the dividends are a direct benefit from the company to its owners. It is an income stream to the owners of equity capital. Many expectations surround the company’s quarterly announcement periods in terms of the dividend declared by the corporate enterprises to its shareholders. The payment of dividend itself is expected to influence the share price of the company. To the extent that cash goes out of the company, the book value of the company stands reduced and it is theoretically expected to lower the market price of the share. This is based on the argument that future expectations are exchanged for current benefits from the company in the form of dividends. While bonus shares do not reduce the cash flow of the company, they increase the future obligations of the company to pay extra dividend in the future. Bonus shares result in an increase in the number of existing shares. Hence, the company has to pay dividend on its newly issued bonus shares in addition to its existing number of shares. These bonus shares are different from stock splits. Stock splits simply imply a reduction in the face value of the instrument with an increase in the quantity of stock. A stock split does not increase the value of current equity capital. Bonus shares, on the other hand, increase the value of equity capital to the company.

Valuation is the process of assigning a rupee value to a specific share. An ideal share valuation technique would assign an accurate value to all shares. Share valuation is a complex topic and no single valuation model can truly predict the intrinsic value of a share. Likewise, no valuation model can predict with certainty how the price of a share will vary in the future. However, valuation models can provide a basis to compare the relative merits of two different shares. Common ways for equity valuations could be classified into the following categories:

 1. Earnings valuation

2. Cash flow valuation

3. Asset valuation

4. Dividend-discount model

Earnings valuation - Earnings (net income or net profit) is the money left after a company meets all its expenditure. To allow for comparisons across companies and time, the measure of earnings is stated as earnings per share (EPS). This figure is arrived at by dividing the earnings by the total number of shares outstanding. Thus, if a company has one crore shares outstanding and has earned Rs. 2 crore in the past 12 months, it has an EPS of Rs. 2.00. Rs. 20,000,000/10,000,000 shares = Rs. 2.00 earnings per share EPS alone would not be able to measure if a company’s share in the market is undervalued or overalued. Another measure used to arrive at investment valuation is the Price/Earnings (P/E) ratio that relates the market price of a share with its earnings per share. The P/E ratio divides the share price by the EPS of the last four quarters. For example, if a company is currently trading at Rs. 150 per share with a EPS of Rs. 5 per share, it would have a P/E of 30. The P/E ratio or multiplier has been used most often to make an investment decision. A high P/E multiplier implies that the market has overvalued the security and a low P/E multiplier gives the impression that the market has undervalued the security. When the P/E multiple is low, it implies that the earnings per share is comparatively higher than the prevailing market price. Hence, the conclusion that the company has been ‘undervalued’ by the market. Assume a P/E multiplier of 1.0. The implication is that the earnings per share is equal to the prevalent market price. While market price is an expectation of the future worth of the firm, the earnings per share is the current results of the firm. Hence, the notion that the firm has been ‘undervalued’ by the market. On the other hand, a high P/E ratio would imply that the market is ‘overvaluing’ the security for a given level of earnings.

Cash flows valuation -  Cash flows indicate the net of inflows less outflows from operations. Cash flows differ from book profits reported by companies since accounting profits identify expenses that are non-cash items such as depreciation. Cash flows can also be used in the valuation of shares. It is used for valuing public and private companies by investment bankers. Cash flow is normally defined as earnings before depreciation, interest, taxes, and other amortisation expenses (EBDIT). There are also valuation methods that use free cash flows. Free cash flows is the money earned from operations that a business can use without any constraints. Free cash flows are computed as cash from operations less capital expenditures, which are invested in property, plant and machinery and so on. EBDIT is relevant since interest income and expense, as well as taxes, are all ignored because cash flow is designed to focus on the operating business and not secondary costs or profits. Taxes especially depend on the legal rules and regulation of a given year and hence can cause dramatic fluctuations in earning power. The company makes tax provisions in the year in which the profits accrue while the real tax payments will be made the following year. This is likely to overstate/ understate the profit of the current year. Depreciation and amortisation, are called non-cash charges, as the company is not actually spending any money on them. Rather, depreciation is an accounting allocation for tax purposes that allows companies to save on capital expenditures as plant and equipment age by the year or their use deteriorates in value as time goes by. Amortisation is writing off a capital expenses from current year profit. Such amortised expenses are also the setting aside of profit rather than involving real cash outflows. Considering that they are not actual cash expenditures, rather than accounting profits, cash profits will indicate the real strength of the company while evaluating its worth in the market. Cash flow is most commonly used to value industries that involve tremendous initial project (capital) expenditures and hence have large amortisation burdens. These companies take a longer time to recoup their initial investments and hence tend to report negative earnings for years due to the huge capital expense, even though their cash flow has actually grown in these years. The most common valuation application of EBDIT is the discounted cash flow method, where the forecast of cash flows over a period fo time are made and these are discounted for their present worth Buying a company with good cash flows can yield a lot of benefits to an investor. Cash can fund product development and strategic acquisitions and can be used to meet operational and financial expenditures. Cash forecasts are made for a limited time duration. However, the shares are valued for their ability to produce an indefinite stream of cash flows. This is referred to as the terminal value of shares. Terminal value usually refers to the value of the company (or equity) at the end of a high growth period. When an indefinite duration of growth is considered, it is normal to assume that a stable growth will follow the high growth. This stable growth rate is expected to remain constant.

Asset valuation - Expectation of earnings, and cash flows alone may not be able to identify the correct value of a company. This is because the intangibles such as brand names give credentials for a business. In view of this, investors have begun to consider the valuation of equity through the company’s assets. Asset valuation is an accounting convention that includes a company’s liquid assets such as cash, immovable assets such as real estate, as well as intangible assets. This is an overall measure of how much liquidation value a company has if all of its assets were sold off. All types of assets, irrespective of whether those assets are office buildings, desks, inventory in the form of products for sale or raw materials and so on are considered for valuation. Asset valuation gives the exact book value of the company. Book value is the value of a company that can be found on the balance sheet. A company’s total asset value is divided by the current number of shares outstanding to calculate the book value per share. This can also be found through the following method- the value of the total assets of a company less the long-term debt obligations divided by the current number of share outstanding.

Dividend discount model -According to the dividend discount model, conceptually a very sound approach, the value of an equity share is equal to the present value of dividends expected from its ownership plus the present value of the sale price expected when the equity share is sold. For applying the dividend discount model, we will make the following assumptions: (i) dividends are paid annually- this seems to be a common practice for business firms in India; and (ii) the first dividend is received one year after the equity share is bought

Single-period valuation model - Let us begin with the case where the investor expects to hold the equity share for one year. The price of the equity share will be: P0 = D /(1 + r) 1 + P /(1 + r) 1 Where, P0 = current price of the equity share; D1 = dividend expected a year hence; P1 = price of the share expected a year hence; and r = rate of return required on the equity share.

Multi-period valuation - Model Having learnt the basics of equity share valuation in a single-period framework, we now discuss the more realistic, and also the more complex, case of multiperiod valuation. Since equity shares have no maturity period, they may be expected to bring a dividend stream of infinite duration. Hence the value of an equity share may be put as:

This is the same as Eq. which may be regarded as a generalised multi-period valuation formula. Eq. is general enough to permit any dividend pattern-constant, rising, declining, or randomly fluctuating. For practical applications it is helpful to make simplifying assumptions about the pattern of dividend growth. The more commonly used assumptions are as follows:

 • The dividend per share remains constant forever, implying that the growth rate is nil (the zero growth model).

 • The dividend per share grows at a constant rate per year forever (the constant growth model).

 • The dividend per share grows at a constant extraordinary rate for a finite period, followed by a constant normal rate of growth forever thereafter (the two-stage model). • The dividend per share, currently growing at an above-normal rate, experiences a gradually declining rate of growth for a while. Thereafter, it grows at a constant normal rate (the H model)

Zero Growth model - If we assume that the dividend per share remains constant year after year at a value of D, Eq. (b) becomes:

Remember that this is a straightforward application of the present value of perpetuity formula discussed in the previous chapter.

Constant growth model - One of the most popular dividend discount models assumes that the dividend per share grows at a constant rate (g). The value of a share, under this assumption, is:

Two stage growth model - The simplest extension of the constant growth model assumes that extraordinary growth (good or bad) will continue for a finite number of years and thereafter normal growth rate will prevail indefinitely.

Impact of growth on price, returns, and P/E Ratio The expected growth rates of companies differ widely. Some companies are expected to remain virtually stagnant or grow slowly; other companies are expected to show normal growth; still others are expected to achieve supernormal growth rate. Assuming a constant total required return, differing expected growth rates mean differing stock prices, dividend yields, capital gains yields, and price-earnings ratios

Multi-factor share valuation - Quantitative approaches convert a hypothetical relationship between numbers into a unique set of equations. These equations mostly consider company-level data such as market capitalisation, P/E ratio, book-to-price ratio, expectations in earnings, and so on. Quantitative methods assume that these factors are associated with shares returns, and that certain combinations of these factors can help in assessing the value and, further, predict future values. When several factors are expected to influence share price, a multi-factor model is applied in share valuation. The choice of the right combination of factors, and how to weigh their relative importance (that is, predicting factor returns) may be achieved through quantitative multivariate statistical tools. Many factors that have been considered individually can be combined to arrive at a best-fit model for valuing equity shares. Value factors such as price to book, price to sales, and P/E or growth factors such as earnings estimates or earnings per share growth rates, can be used to develop the quantitative model. These quantitative models help to determine what factors best determine valuation during certain market periods. These multifactor share valuation models can also be used to forecast future share values.