Business/Financial Assets Valuation model

INTRODUCTION
Valuation is the process of estimating the worthiness of a given financial assets and liabilities.
DEFINATION OF TERMS
1. Market value.
It is the price at which the securities are currently trading for in the market. This value is
determined by the market forces of demand and supply.
2. Book value/Face value/Nominal value/Par value
It is the original price of a financial asset/security i.e. ordinary shares, preference shares and long
term debt/debentures/bands. It is the price at which securities were issued for the first time i.e. the
balance sheet value.
This value is historical and it helps in determining the number of securities issued when raising a
given amount.
3. Replacement value.
It is an equivalent value of a given financial asset to another i.e. the value of one asset that is
enough to replace another asset.
4. Intrinsic value.
It is the present value of expected cash inflows from a given security.
This value is therefore determined by discounting the expected cash inflows of a given security
using cost of capital as the discount factor.
This value is also known as fair market value/the true value of an asset.
5. Conversion value.
Refers to the financial worth of the securities obtained by exchanging a convertible security for its
underlying assets. Convertibles are a category of financial instruments, such as convertible bonds
and preferred shares, which can be exchanged for an underlying asset, such as common stock.
REASONS FOR VALUING FINANCIAL ASSETS
- To Ensure the Right Price is paid
- For Taxes purposes
- To analyze investment potential
- For Financial reports and audits
- For mergers and acquisitions
- Loan Applications

THEORIES ON VALUATION OF FINANCIAL ASSETS

These include:
1. Fundamental theory
2. Technical/chartist theory
3. Random walk theory

Fundamental theory
This theory states that every security has an implicit value, which is equal to the present value of all
cash flows expected from the company. The value of the security should therefore be equal to the
present value of all the future benefits expected from that security. The assumption is that the
company follows a constant dividend policy.

Technical/Chartist Theory
This holds that historic price patterns are expected in the future. This price patterns can be
 subdivided into:

 Primary movements – Which are long term in nature. This is a trend that represents a period
greater than one year.
 Secondary movement– These are seasonal variations in the share price capturing periods covering
several weeks.
 Tertiary movements – These refer to the daily changes in stock prices. This theory ignores the
tertiary movements and uses the secondary movement to determine changes in primary
movements.

Random walk theory

This theory holds that prices of securities depend on factors that affect expected return and
expected risk. Information about these factors is released to the markets at different intervals and
investors react differently to the information. Security prices therefore follow a random walk trend
and cannot therefore be predicted. It has the support of the efficient market hypothesis.

THE EFFIFICENT MAKET HYPOTHESIS (EMH)

This hypothesis argues that information whether good or bad once released to the market, will be
quickly digested and reflected in the security price. Should a company release bad news to the
market, this will lead to the decline in its security price. Also, should a company release good news
such as declaring high dividends, this will lead to the increase in its security price. The efficiency
of the stock exchange is determined by the speed at which new information is reflected in the
security price.
Types of market efficiency
There are three types of market efficiency i.e.
(a) Allocative efficiency: This refers to the ability of the market to channel funds to those companies
that can best use them. This means that high growth sectors such as technology and electronics tend
to be allocated more funds by the market than low growth sectors.
(b) Operational efficiency; as the title suggests this refers to the operation of the market, maintaining
fair competition, keeping transaction costs as low as possible, reducing barriers to trade and trading
quickly.
(c) Pricing efficiency; in pricing efficiency market the share prices react instantaneously, rationally
and fairly to any news. If the news is good, the price goes up and vice versa.
The hypothesis of the efficient market derives from this last form of efficiency and can be stated as;
in an efficient market, price of securities fully and fairly reflect all relevant available information.
Roberts (1957) suggested that the capital market could be efficient at one or more of three levels,.
These include:
a) The strong form of market efficiency. This occurs when the security prices reflects the past
(historical) presence (published) and future (confidential) information about the company’s
performance. The confidential information may include information such as the board of director’s
decision to offer a right issue which has not been officially announced to the general public.
b) The semi-strong form of market efficiency; Under this form, the security price is determined using
only the present or published and the past or historical information. Hence in this case, the
confidential information is not available.
c) Weak form of market efficiency; This occurs when the security price only reflects the past or
historical information alone.

VALUATION OF FIXED INCOME SECURITIES

 These instruments are called fixed income securities because they provide periodic income
payments at a predetermined fixed interest rate. The borrower issues bonds to raise debt from
investors with a promise to repay the principal on a fixed date and to make pre-scheduled interest
payments.

1. VALUATION OF PREFERENCE SHARES

Preferred stock/preference shares attract a fixed amount of preference dividends over a given
period (an annuity) and the redemption value if any upon maturity.
To calculate the intrinsic value of preference shares, we discount the expected cash flows using the
cost of preference shares (KP) as the discount factor.
Preference shares are of two forms i.e.
Irredeemable preference shares
Redeemable preference shares
Valuation of irredeemable preference shares.
These are preference shares that do not mature hence they attract a fixed amount of dividends to
infinity/perpetuity.
The intrinsic value of irredeemable preference shares will therefore be the infinite stream of
expected dividends discounted using cost of preference shares (KP) that is:-
MVP= Preference dividends x PVIFA

Preference dividends
∴MVP =
Kp

Where: MVP = Intrinsic value/fair market value per share

KP = Cost of preferences shares/investors required rate of return

Illustration
1. 8% irredeemable preference share with a par value of Ksh 200 is to be issued by the firm. If the
cost of capital is 16%, calculate the intrinsic value per share..
2. A firm issued 10% preference shares to raise funds. The shares have a par value of Sh.100
each and are currently selling at Sh.110 each. The minimum rate of return 8%

Valuation of redeemable preference shares

These shares attracts a fixed amount of preference dividends for a given period (an annuity) and a
redemption value upon maturity (lumpsum)
The intrinsic value is therefore determined by discounting both the preference dividends and the
redemption value i.e.
MVP = Preference dividends x PVIFA KPnyrs + Redemption Value x PVIF KPnyrs
MVP = Preference dividends (Annuity) x PVIFA KPnyrs + Redemption value(Lumpsum) x
PVIF KPnyrs
 Illustration
1. 8% preference shares with a par value of Ksh 100 are to be isued. If the required rate of return is
12% and the shares are redeemable in 4 years, calculate their market value assuming they are
redeemed.
a. At par
b. At a discount of 15%
c. At a premium of 15%
2. 10% Sh. 120 preference shares have a maturity period of 8 years. The dividends paid semi-annually
and cost of capital is 18% p.a.
Required;-
Determine the highest amount that each share should be sold for.

2 VALUATION OF BONDS / DEBENTURES

Bonds are fixed income securities which promises to pay fixed amount of interests over a
given period (annuity) and the redemption or conversion value if any upon maturity
(lumpsum).
There are three types of Bonds i.e.
- Irredeemable bonds (loans stock)
- Redeemable Bonds
- Convertible Bonds

(i)Valuation of irredeemable bonds

These bonds attract a fixed amount of interest to infinity.
Their intrinsic value is therefore the present value of the infinite steam of interest payment
discounted using cost of debt (Kd) i.e.
MV = Interest x PVIFA Kd, ∝
Interest
MV =
kd
Where: MV = Intrinsic fair market value of bond.
Kd = Cost of debt/investors required rate of return

Illustration
A 12% p.a. sh 1000 irredeemable bond is to be issued. The bond would attract interest
semi-annually and the investors’ required rate of return is 20% per annum.
Required;-
Determine the minimum price of which each bond should be sold.

(ii)Valuation of redeemable bonds and convertible bonds.

These bonds have a maturity period. They would therefore attract a fixed amount of
interest for a given period (an annuity) and upon maturity they would either be redeemed
or converted into other securities, mostly ordinary shares i.e. a lumpsum.
The intrinsic value shall therefore be the present value of expected cash flow that is:-
For a redeemable bond:
MV = Interest x PVIFA Kdnyrs + Redemption value x PVIF Kd nyrs
For a convertible bond:
 MV = Interest x PVIFA Kd nyrs + conversion value x PVIF Kd nyrs

Illustration
1. James Chiwende is considering the purchase of a 4-year sh 1,200,000 par value bond.
The bond has a coupon interest rate of 10% per annum.
The investor’s required rate of return is 8%.
Required:
The current value of the bond.
2. Ngatia Limited has issued a 20-year bond with a nominal value of Sh.1, 000 and a
coupon annual rate of 9%. Coupon payments are made semi-annually in arrears. The
yield to maturity of the bond is 12% per annum.
Required:
(i) The value of the bond.
(ii) The new value of the bond, if yield to maturity goes down to 8% per annum.

3. Safaris Limited is currently issuing 9% bonds redeemable at Sh.100 par value in five
years’ time. Alternatively, each bond may be converted on that date into 20 ordinary
shares of the company. The current market price per share is Sh.4.45 and this is
expected to grow at the rate of 6.5% per annum for the foreseeable future. The
company’s cost of debt is 7% per annum.
Required:
(i) Market value of the bond
(ii) Floor value of the bond
(iii) Conversion premium per share.
Floor value of the Bond – Floor value of a bond refers to the lowest value that convertible bonds
can fall to, given the value of the remaining future cash flows and principal repayment.
It is calculated using the real/type nature of the bond i.e. this bond is redeemable hence;
Floor Value = Interest x PVIFA Kdnyrs + Redemption value x PVIF Kd nyrs
Conversion premium per share
It is the difference between conversion value in future and conversion value today.
 VALUATION OF VARRIABLE INCOME SECURITIES
These instruments are called varriable income securities because they don’t provide periodic
income payments. Example is the ordinary shares.

METHODS OF VALUING ORDINARY SHARES

The common methods of valuing ordinary shares include:-
a) The P/E ratio method
b) Gordon’s valuation method
c) Net asset or liquidation method
d) The super profits method.

a) Price earnings ratio method

This method is used by those companies which are listed in the stock exchange where the
market price per share is determined by the force of demand and supply.
MPS
P/E ratio =
EPS
Therefore MPS = P/E ratio × EPS

Example
A company has reported earnings per share of sh.5.0 in the latest financial period, if the
price earnings ratio of the firm is 15, calculate the theoretical market price per share.

b) The Gordon’s valuation model

This method uses the fundamental theory to value an ordinary share. In this case, the intrinsic or
theoretical value of an ordinary share is equal to the present value of all the expected future
benefits to be realized from the ordinary share. This method is used by investors who are interested
in dividends because they cannot influence the management and control during the AGM. For the
purpose of valuing the ordinary shares, Gordon classified the ordinary shares into 3 categories
namely;
1. Zero dividend growth rate ordinary shares.
2. Constant dividend growth rate ordinary shares.
3. Non-constant dividend growth rate ordinary shares.

d) Super profits method

This method considers both the tangible and intangible assets in determining the theoretical value
of the share. The intangible assets are determined using the super profits method. The super profits
refer to the returns in excess of the fair value of the amount realized from the utilization of the
assets. The super profits are usually earned by the company for a given number of years in the
future. These numbers of years are known as the years of purchase. When using this method the
theoretical value of the share is calculated using the formula.
TangibleAssets+ IntangibleAssets
Po =
Number of ordinary shares
Where:
Intangible assets = Super Profits × No. of years of purchase
 Illustration
ABC Ltd has net tangible assets worth sh.48m and the return of these net assets is 12%. The
company expects to receive sh.10m as profits per year for the next 5 years. The company has
2,000,000 ordinary shares outstanding.
Required:
Determine the theoretical value of the company’s ordinary share using the super profits method.

The dividends/gordons growth model of valuing shares

Ordinary shares attract the ordinary share dividends which may not be fixed.
The firm is not under any legal obligation to pay dividends to ordinary shareholders.
The intrinsic value of ordinary shares shall therefore be the present value of expected dividends
paid to infinite i.e. ordinary shares do not mature.

In valuation of ordinary shares, firms are categorised into three:

a) A non-growth firm
b) A normal growth firm
c) A super normal growth firm

VALUATION OF ORDINARY SHARES IN A NON-GROWTH FIRM

This is a firm that pays a fixed amount of dividends to infinity i.e. the dividend does not
grow/increase.
It is assumed that firms are always profitable and pays dividends annually from the profits.
The intrinsic value of ordinary shares in a non-growth firm shall be the present value of expected
dividends (D1) discounted using cost of Equity (Ke) that is:-

D1
PO =
Ke

Where: - PO = Intrinsic value/fair/market value of ordinary shares

D1 = Expected Dividends/Next year’s dividend.
Ke = Cost of Equity/Required rate of return by ordinary shareholders

Illustration
1. A company expects to pay a dividend of Sh. 3 on its ordinary shares which is expected to
remain constant throughout. Calculate the intrinsic value per share if the cost of equity (Ke) is
14% p.a.

2. The ordinary shares of Ujuzi Ltd are currently trading at Ksh. 60 on the market. The company
pays a fixed amount of dividends of Ksh. 6 per share and the cost of equity is 8%.
Required;-
Advise a potential investor on whether to buy or sell the shares

VALUATION OF ORDINARY SHARES IN A NORMAL GROWTH FIRM

In this case the dividends increase (growth of a constant rate throughout).
The intrinsic value of ordinary shares in a normal growth firm shall be the present value of
expected dividends discounted using Ke less the growth rate of dividends i.e.
D1
Po =
Ke−g
 Where: Po = Intrinsic value/fair market value per share
Ke = Cost of Equity/Required rate of return by ordinary shareholders.
g = dividend growth rate
D1 = Expected dividends/Next year’s dividends
NOTE:
DIllustration
1 = Do (1 + g)
1. A company has just paid a dividend of Sh. 4 which grows at a constant rate of Ksh 6% p.a. and
Where: Do = Current year’s dividends/ dividend for the year just ended.
the cost of equity is 10%.
Required;-
Calculate the market value of the share

2. The expected dividends of ABC Limited is Sh.6 per share. The dividend growth rate is 4% p.a.
and investors required rate of return is 12% per annum.
Required;-
Calculate the intrinsic value per share

3. The company expects to pay a dividend of Ksh 12 in a weeks time. Dividends growth on average
at the rate of 8% p.a. and cost of equity is 20%.
Required
Calculate the intrinsic value per share

4. Ngoba Ltd has just paid an annual dividend of Sh.38 per share. The management of the company
has a target to increase the market share value to Sh.800 per share by considering appropriate
policies.
Required:
The annual expected growth rate.

VALUATION OF ORDINARY SHARES IN A SUPER NORMAL GROWTH FIRM

In this case dividends are expected to grow at a very high rate in the initial stages of the firm. This
is because of the high demand of the firms products.
With time, the growth rate in dividends is expected to decline up to a point where it will stabilise
and dividends will grow at a constant rate throughout.
The intrinsic value of ordinary shares in a supernormal growth firm is therefore the total of the
present value of expected cash flows i.e.
a) PV of expected dividends (D1) up to the point of stabilisation D1 = Do (1+g)
D1
b) PV of the shares (Po) immediately after stabilisation point Po =
Ke−g

Illustration
1. Chigiri Ltd is a private company which intends to be listed in the securities exchange. The
company has recently made a dividend issue of Sh.3.20 per share. This dividend is expected to
grow at the rate of 15% per annum for 2 years and then drop to 12% per annum for the next 3
years. Thereafter, the dividend will grow at 6% per annum indefinitely. The required rate of return
is 11%.
Required:
The intrinsic value of the share.

2. Bundacho Ltd generated Sh.50 million profits after-tax in the previous financial year. The firm
adopts 40% pay-out ratio as its dividend policy. The total numbers of issued ordinary shares are
 10,000,000.
The company has a potential investment opportunity. If undertaken, dividends are expected to grow
at the rate of 10% each year for the first 3 years and then stabilize at the rate of 5% each year
thereafter in perpetuity.
The investor’s minimum required rate is 18%
Required;-
The current intrinsic value of the share.

3. Zedi Ltd is forecasting a growth rate of 12% per annum for the next two years. The growth rate is
likely to fall to 10% for the third and fourth years. After that, the growth rate is expected to
stabilise at 8% per annum. The company has just paid a dividend of sh. 1.50 per share and the
investors required rate of return is 16%.
Required:
The intrinsic value per share of Zedi Ltd.

4. Remarex Limited’s earnings have been growing at the rate of 18% per annum. This growth is
expected to continue for 4 years, after which the growth rate will fall to 12% per annum for another
4 years.
Thereafter, the growth rate is expected to be 6% in perpetuity. The company’s last dividend paid
was sh.2. The investors’ required rate of return on the company’s equity is 15%.

Required:
The intrinsic value of the share.