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SECURITIES RETURN AND VALUATION ANALYSIS
GROUP NO 3
SR. NO NAME OF THE STUDENT TOPIC TO BE COVERED ROLL NO
1. ZAMILA PACECHO FIXED INCOME SECURITIES- MEANING, MERITS AND DEMERITS.
39
2. SONALY SATARKAR TYPES OF FIXED INCOME SECURITIES 47
3. MABEL SOARES RISK FACTORS IN FIXED INCOME SECURITIES
51
4. FRAZER TAYLOR BONDS- MEANING, TYPES, FACTORS AFFECTING BOND RATING PROCESS
53
5. BLOSSOM REBELLO BOND RETURNS 44
PRESENTATION ORDER
SR. NO NAME OF THE STUDENT TOPIC TO BE COVERED ROLL NO
6. SHWETA PARAB CONCEPT OF YIELD 41
7. CLENCY COUTINHO CONCEPT OF CONVEXITY 04
8. TANVI SHENOY STOCK RETURN AND VALUATION 49
9. PRIYANKA VELGENKAR ‘’ 55
PRESENTATION ORDER
FIXED
INCOME
SECURITIES
ASSET CLASSES
EQUITY
REAL ESTATE COMMODITY
FIXED INCOME
ASSET CLASSES IN THE MARKET
Meaning of fixed Income Securities:-
Fixed Income securities refer to investments in debt securities that pay a defined coupon(interest) rate for a given period of time and repay the face value of the security at maturity.
Government securities, corporate bonds, Treasury Bills, Commercial Paper are some examples of fixed income securities.
BENEFITS OF INVESTING IN FIXED INCOME SECURITIES
Fixed income securities are an excellent choice for risk-averse investors seeking a stable source of income.
Ability to earn better returns than bank deposits.
Protection against loss in a cyclical downturn.
•Ability to diversify the range of portfolio maturities.
Diversification
Liquidity e.g. Government Bonds, Treasury bills
Capital stability
Regular income
Not suitable for investors who aim for high returns by taking high risks.
A portfolio over weighted with fixed-income investments may make you more vulnerable to inflation risk.
The bond market is at the mercy of interest rates and can be unpredictable. Therefore subject to Interest rate risk.
Other risks surrounding fixed-income securities include reinvestment risk and credit quality risk.
. Liquidity risk: investors money is locked for full maturity period so except for government debt, It is difficult to sell any other type of debt.
Not actively traded: this lack of competition prevents their prices rising very high.
DISADVANTAGES OF INVESTING IN FIXED INCOME SECURITIES
TYPES OF FIXED INCOME SECURITIES
• The types of Fixed Income securities are based on their issuance
GOVERNMENT
BANKS / FIs
TREASURY BILLS
COMPANIES
G - SECURITIES
CERTIFICATES OF DEPOSIT
BONDS COMMERCIAL PAPERS
TREASURY BILLS • Treasury Bills are short-term money market instruments that
finance the short term requirements of the Government. • They are offered at a discount on their face value and at the
end of the maturity period, they are repaid at their face value. • T-bills are issued in denominations of Rs. 25,000 with the
minimum amount being Rs. 25,000. • Treasury bills can be obtained both, in the primary and
secondary markets• There are three types of T-bills, they are 3 months, 6 months
and 1 year
GOVERNMENT SECURITIES
• Government Securities (G-Secs) are tradable sovereign securities issued by the Central and the State Governments, indicating a debt obligation in order to finance government expenditure.
• G-Secs are long term securities with maturities ranging up to 30 years.
• Government securities are issued through auctions conducted by RBI on an electronic portal.
TYPES OF GOVERNMENT SECURITIES
1. Fixed Rate Bonds: These securities have a fixed interest rate attached to them payable at regular intervals throughout the maturity period.
2. Floating Rate Bonds: These securities have a variable interest rate which is reset at fixed time intervals. The interest rate on these bonds comprises of a base rate which is the weighted average cut-off yield of 3 one year T-bills, and the reset rate is added on to the base rate to arrive at the coupon rate for the bond.
3. Special Securities: These are untradeable government securities (unlike the other types) and are issued to finance specific government projects.
• Some other government securities that are not very commonly found in the markets are Call/Put Option Securities, Capital Indexed Securities and State Development Loans.
CERTIFICATES OF DEPOSIT
• Certificate of Deposit or CD is a financial instrument issued by banks or other financial institutions (FIs) except Regional Rural Banks (RRBs) and Local Area Banks (LABs).
• CDs are an acknowledgement of the deposit of funds with a bank or FI.
• They carry a fixed rate of interest which will be paid at the end of the specified maturity period.
• They are different from a traditional bank deposit as they can be traded in the secondary market.
• They also cannot be redeemed when needed as they have a maturity period attached to them, or they carry very heavy penalties on early termination.
• CDs issued by banks can have maturity period between 7 days and 1 year, and those issued by FIs can have maturity from one to three years.
• Minimum investment amount is Rs. 1 lakh and incremental investments have to be in multiples of the same.
COMMERCIAL PAPER
• Commercial Papers (CPs) are issued by companies, Primary Dealers (PDs) and other Financial Institutions (FIs) as an acknowledgement of borrowing from the public.
• CPs allows the companies to raise funds for current or short- term expenses like inventories
• CPs have a maturity period ranging from 15 days to a maximum of one year, and they cannot be traded in the secondary market
• The minimum investment amount in CPs is Rs. 5 lakhs.
BONDS
• Bonds, or debentures, are issued by companies and financial institutions as a means of raising money from the markets in the form of loans.
• The interest on the bond is pre-determined by the issuer. • Maturity period of bonds is generally between five to seven
years.• Some bonds may also carry additional benefits like „call‟ or
„conversion‟ options. • Bonds are also traded in the secondary markets, though the
volumes are not very high as most investors hold bonds up to maturity.
• Public issue of bonds by a company is similar to equity IPOs
RISK FACTORS IN FIXED INCOME
SECURITIES
INTEREST RATE RISK
• Variability in the return of the debt instruments due to the change in the market interest rate is Known as Interest rate risk.
• There is a relationship between the coupon rate and market interest rate.
• The market value of the securities will be inversely affected by movements in interest rates.
• When rates are rising, market prices of existing debt securities will fall, as demand increases for new-issue securities with the higher rates.
• When rates are falling, market prices will rise, because the higher rates on outstanding debt securities will be more valuable.
DEFAULT RISKThe failure to pay the agreed value of the debt
instrument by the issuer in full, on time or both are the default Risk.
The safety of a fixed-income investor’s principal depends on the issuer’s credit quality and ability to meet its financial obligations.
Issuers with lower credit ratings usually have to offer investors higher yields to compensate for the additional credit risk.
In order to avoid default risk RBI & SEBI are using credit rating agencies to determine the eligibility of the fixed income instruments such as ICAR, CARE & CRISIL .
MARKETABILITY RISK
• Variability in return caused due to the difficulty in selling the bond quickly is known as Marketability risk.
• The marketability or liquidity of particular bond depends upon the corporate image.
• All the bonds are not highly liquid; some trade very infrequently, which can present a problem for investor who want to sell before maturity.
• Liquidity risk can be greater for bonds that have lower credit ratings, managerial inefficiencies or fall in the profits of the company.
CALLABILITY RISK
The uncertainty created in the investor’s return by the issuer’s ability to call the bonds at any time is known as Callability Risk.
The call option provides the issuer the right to call back the instruments at any time by redeeming them.
When interest rates declines the issuer can call the bonds with high interest rate and again raise funds at a lower interest rate.
Thus its an uncertainty of maturity period for the investors.
BOND ANALYSIS
MEANING OF BOND
• A form of a Loan.
• A formal contract.
• E.g.. The Chair maker Co.Ltd
• Difference between Bonds and Stocks
Why Do People Buy Bonds?
• Diversification
• Security
• Income
• Liquidity
• Tax Advantages
TYPES OF BOND
1. Government Bonds
2. Corporate Bonds
3. Banks and other Financial
Institution Bonds
4. Zero coupon Bonds
5. Tax saving Bonds
1.Government Bonds
• Sold on a private basis.
• Investment Banker
• Secured Bond
• Rate of interest
2.Corporate Bonds
• Traditional Bond instruments
• Secured and Non- Secured Bonds
• Higher risk of default
3.Banks and Other Financial Institutions Bonds
• Issued by Banks or any Financial Institutions
• Majority of the Bonds issued are from this segment
• Credit rating
4.Zero Coupon Bonds
• Short term or long term investment
• It does not come with a interest rate
• Offered at a discount
5.Tax Saving Bonds
• Issued by the Government
• 5 year bond
• Advantage to the Investors.
Credit Rating
• Assessment of borrowers credit quality
• Not a recommendation to buy, hold or sell
• Credit rating agency
Why is Credit rating important??
• Investors
• Issuers
• Financial Intermediaries
• Market Regulators
Rating Symbols
SYMBOL (RATING CATEGORY) DESCRIPTION (WITH REGARD TO THE LIKELIHOOD OF MEETING THE DEBT OBLIGATIONS ON TIME)
AAA Highest Safety
AA High Safety
A Adequate Safety
BBB Moderate Safety
BB Inadequate Safety
B High Risk
C Substantial Risk
D Default
Limitations of Credit Rating
• Credibility of rating is questionable
• Creates a confusion in the minds of the investors
• Rating agencies do not perform audit
• It leads to conflict of interest
BOND RETURN
BOND TERMS:
• Par ValuePar value is the amount of money (usually Rs1000 per
bond) that will be returned to the bondholder at the maturity date.
• CouponThe interest the bond pays annually.
• Coupon RateThe coupon rate is the coupon (interest) divided by par
value. If a bond pays Rs 20 annually it has of coupon rate of 2% (Rs20 divided by Rs1,000).
• MaturityMaturity is the length of time before the bond issuer pays
the par value to the bond holder. Obviously, the maturity decreases as time passes.
HOLDING PERIOD RETURN
• Holding period return (HPR) is the total return on an asset or portfolio over the period during which it was held.
• It is one of the simplest measures of investment performance.
• The return earned from the act of holding an asset over a given period.
• The return is equal to the income and other gains (such as appreciation) earned from the asset, divided by the original cost of the asset.
• The holding period return can be calculated for any asset, including a bond, an individual stock, or a complete portfolio.
• It is also called the one period rate of return.
Advantages:
It is easy to calculateIt is easy to understandIt considers current income and growth
Disadvantages:
It does not consider time value of money.The rate may be inaccurate if time period is longer
than one year.
Problem1:
A bond is currently worth Rs.600. If you purchased the bond exactly one year ago for Rs.500 and received Rs.200 interest over the course of the year, what is your holding period return?
Solution:
Problem 2:
• An investor ‘A’ purchased a bond at a price of Rs 900 with Rs 100 as coupon payment and sold it at Rs 1000. a) What is his holding period return? b) If the bond is sold for Rs 750 after receiving Rs 100 as coupon payment, then what is the holding period return?
Solution: a)
Thus the Holding Period return is 22.22%
b)
Thus the Holding period return is -5.5%
CONCEPT OF YIELD
The annual rate of return on an Investment.
Expressed annually as a percentage based on the investment's cost, its current market value or its face value.
.
YIELD ON BONDSBonds have the following yields: Coupon (the bond interest rate fixed at issuance) Current (the bond interest rate as a percentage of the
current price of the bond) Yield to Maturity (an estimate of what an investor
will receive if the bond is held to its maturity date).
COUPON RATE• Rate of interest fixed
• Calculated on face value
• Rate at which interest is payable
For exampleIf the coupon rate on a bond of face value of Rs. 1000 is 12%
CURRENT YIELD
The Current Yield relates the annual interest receivable on a bond to its current market price
Expressed as follows.
Where, In = Annual interest P0 = Current market price
For example, if a bond of face value Rs. 1000 and a coupon rate of 12 % ,is currently selling for Rs. 800. find current yield.
Current Yield = In /P0 *100
Cont.…
Then, (1000 *12%)= 120
Current Yield = In /P0 *100= 120/800*100= 15%
If, current yield > coupon rate the bond is selling at a discount And if , current yield< coupon rate than the bond would be sold
a t a premium.
YIELD TO MATURITY (YTM)
• Measure of Return on bonds.
• As the compounded rate of return and investor is expected to receive from a bond purchased at the current market price and held to maturity.
•It depends on Cash Outflow and Cash inflows.
ASSUMPTIONS
• There should not be any default. Coupon and principal amount should be paid as per schedule.
• The investor has to hold the bond till maturity
• All the coupon payments should be reinvested immediately at the same interest rate as the same yield to maturity of the bond.
FORMULA
Where, MP= Current market price of the bond Ct= Cash flow from the bond throughout the holding
period. TV= Terminal cash inflow received at the end of the holding
period.
MP =∑n t=1Ct/(1+YTM)t +TV/(1+YTM)n
WHERE, I=AMOUNT OF ANNUAL INTEREST MV=MATURITY VALUE AT THE END OF THE HOLDING PERIOD. C=COST OR CURRENT MARKET PRICE OF THE BOND. N=HOLDING PERIOD TILL MATURITY
ANOTHER FORMULA
YTM=I+{MV-C}/n/ {MV+C}/2
EXAMPLE
Lets consider a bond of face value of Rs.1000 and a coupon rate of 15%.The current market price of bond is Rs 900 .Five years remain to maturity and the bond is repaid at par.
YTM=150+(1000-900)/5 (1000-900)/2 =150+20/950 =0.1789 =17.89%
DURATION• It is a measurement of how long, in years, it
takes for the price of a bond to be repaid by its internal cash flows.
• It measures, in years, how long it will take for an investor to recover his or her investment from the cash flows of the bond
GENERAL RULE
1. The duration of any bond that pays a coupon will be less than its maturity
2. A zero coupon bond's duration will be equal to its maturity
3. The lower a bond's coupon, the longer its duration
4. The longer a bond's maturity, the longer its duration
FORMULA TO CALCULATE DURATION
Where:D=DurationC=Cash flowsr = current yield to maturityt = Number of years
Examples
1. For an 8% coupon (annual pay) four-year bond with a yield to maturity of 10%
we have,
2. If the coupon were 4% rather than 8%, then
3. For a zero coupon bond with four years to maturity
= 4
1000 (4)(1.10)4
1000(1.10)4
D =
Duration Table for an 11.75% Coupon Bond
• Duration also measures the sensitivity of the price (the value of principal) of a bond to a change in interest rates
• This calculation can help predict the likely changes in the price of a bond given a change in interest rates.
• If the interest rate increases, the bond value will decrease and vice-versa
• For every 1% increase or decrease in interest rates, a bond's price will change approximately by 1% in the opposite direction for every year of duration
Example :
Types of Duration
1. Macaulay Duration – Measures the number of years required to recover the true cost of a bond, taking into account the present value of all coupon and principal payments received in the future.
2. Modified Duration – Measures the sensitivity of a bond's price to interest rate changes.
Why it's useful?
• Duration gives investors a way to compare bonds with different maturities and coupons.
• Bond duration allows investors to predict how sharply the market price of a bond will change as a result of changes in interest rates.
CONVEXITY
A measure of a bond’s actual price change in response to an interest rate change, compared with the estimated price change based on duration alone.
MEANING OF STOCK VALUATION
• The process of calculating the fair market value of a stock by using a predetermined formulas that factors in various economic indicators.
• Stock valuation can be calculated using a number of different methods. It is the method of calculating theoretical values of companies and their stocks.
• The main use of these methods is to predict future market prices, or more generally, potential market prices, and thus to profit from price movement – stocks that are judged undervalued (with respect to their theoretical value) are bought, while stocks that are judged overvalued are sold,.
WHAT IS RETURN?
• Return from the stock includes both current income and capital gain caused by the appreciation of price.
• The income and the capital gain are expressed as a percentage of money invested in the beginning.
FORMULA FOR RATE OF RETURN
• Return=price change + cash dividend ×100 purchase pricei.e. r = P(t+1) -p(t) + D Pt
Example
• Reliance share price on February 28 2013 was Rs.401(P) and the price on October 26, 2013 was Rs.480(pt+1). Dividend received was Rs.35 (D). What is the rate of return?
r = P(t+1) -p(t) + D Pt
= 480-401+35 401
=114 ×100 =28.43% 401
THE ANTICIPATED RETURN
• The calculation of the anticipated return or expected return is different from direct method.
• The future returns are calculated with the help of probability.
• The value of probability ranges from 0 to 1. It will never exceed 1.
• E(R)=∑(probability Pt)(return Rt)
Example
RETURN (Rt) PROBABILITY( Pt) (Pt) (Rt)
10% 0.1 1.0
11% 0.2 2.2
12% 0.4 4.8
13% 0.2 2.6
14% 0.1 1.4
∑(Pt)(Rt) = 12.0
PRESENT VALUE OF THE RETURN
• The present value concept is the fundamental concept used in the share valuation procedure to estimate the intrinsic value of the share.
• The return generally occurs at the end of the period. If it is to be expressed at the beginning of the holding period, it has to be given in terms of present value.
FORMULA
• P0 = D1 + P1
1+r 1+rP0= present selling priceP1= selling price at the end of one yearD1= the dividend received during the one year
holding period.r= investors required rate of return.
• P0 = D1 + P1
1+r 1+rP0 = 0.35 + 421 1+0.20 1+0.20
= 0.29+350.83=351.12
The price or the value of the stock would have to be Rs.351.12. The present stock price is Rs.335 is very low and the investor can buy it.
A investor holds the shares of T.V.S Suzuki from 13.01.12 to 23.01.13.the beginning and the end period prices are Rs.335 and Rs.421.The dividend paid is 35%.Now, if the investor wants to get 20% return by holding T.V.S. Suzuki stock for the year,utilising the details calculate present value of stock.
CONSTANT GROWTH MODEL
Constant growth (Dividend Growth Model): The constant dividend growth model assumes that the stock will pay dividends that grow at a constant rate each year—year after year forever.• Uses present value to value stock• Assumes dividends will grow at a constant rate over time• Works best with established companies with history of steady
dividend payments
This model is applicable when the analyst is able to predict all the three variable in the equation namely 1)Next year dividend2) The firms long term growth rate3) The required rate of return of investorOnce the 3 values are known to the analyst the theoretical value or the present value of the stock can be computed with prevailing price.
If theoretical value > Actual price = buyIf theoretical value < Actual price = sell
Formula
Formula P0= D1 r-g
Where p=present value of stock r =required rate of return g =growth rate D1=next year dividend
The company ABC’s next year dividend per share is expected to be rs.3.50.The dividend in subsequent years is expected to grow at a rate of 10%per year. If the required rate of return is 15% per year, what should be its price? The prevailing market price is rs.75.
Formula P0 = D1 r-gD1=3.50, r=0.15, g=0.10
= 3.5 0.05
=Rs.70
The investor would be willing to pay rs.70 for the share. since the theoretical price is less than the market price, the investor is advised not to buy.
TWO STAGE GROWTH MODEL
The constant growth model is extended to two growth stage model.The growth stages are divided in to two, namely, a period of extraordinary growth(or decline) and a constant growth period of infinite nature.The extra ordinary growth period will continue for some period followed by the constant growth rate.e.g. Information technology industry is at present is in extraordinary growth rate, it will continue for sometime and afterwards it may maintain constant growth rate.
The present value of the stock or price
= present value of the dividend during the above normal growth period
Present value of stock price at the end of the above normal growth period
P0= n Ʃ D0(1+gs)t + Dn+1 × 1 (1+rs)t
(rs-gn)
(1+rs)n
Do=Dividend of the previous periodgs= Above normal growth rategn= Normal growth raters= Required rate of returnN=Period of above-normal growth
Example:According to the financial express report, October 1998,the rate of
return of Nagarjuna Fertilizer is for the past five years is 18.58%.This is assumed to continue for next five years and after that rate of return is assumed to have a growth rate of 10% indefinitely. The dividend paid for the year1997-98 is 18%.the required rate of return is 20%.the price is Rs 14 on 14.10.98.estimate the stock price according to the two stage model.
Solution P0=nƩ D0(1+gs)t
+ Dn+1 × 1
(1+rs)t (rs-gn) (1+rs)n
• Do=Rs 1.80• gs= 18.58% or 0.1858• gn= 10% or 0.10• rs=20% or 0.20• N=5 years
Step 1nƩ Do(1+gs)t
(1+rs)t =1.8(1.1858)
1 + 1.8(1.1858)
2 + 1.8(1.1858)
3 + 1.8(1.1858)
4 +
1.8(1.858)5
(1+0.2)1 (1+0.2)2 (1+0.2)3
(1+0.2)4
(1+0.2)5
= 2.1344 + 2.531 + 3.0013 + 3.5589 + 4.2201 1.2 1.44 1.728 2.0736 2.488
= 1.779 + 1.758 + 1.737+ 1.716+ 1.696= 8.686
Step 2 = Dn+1 (rs-gn)Dn+1 is the fifth year’s dividend growing at 10% rate
Dn+1=Rs 4.2201×1.10
Dn+1=Rs4.642
Dn+1= 4.642rs- gn 0.2-0.1
=46.42
Step 3= Dn+1 × 1 (rs-gn) (1+rs) n
= 46.42 2.488= Rs18.6575
Step 4P0=nƩ D0(1+gs)t + Dn+1 × 1 (1+rs)t (rs-gn) (1+rs)N
=Rs8.686+ 18.6575 =Rs 27.34 The computed value, Rs 27.34 is higher than the market
price, Rs 14
THE THREE-PHASE MODEL Three phases of dividend growth pattern is
assumed. Dividends are assumed to grow at a constant rate
‘ga’ for a period of ‘A’ years. After the phase ‘A’, the growth rate of dividend
declines for A+1 years through out the phase B and the decline in the dividend rate would be linear.
Afterwards there would be perpetual growth rate ‘gn'.some times the ‘ga’ would be less than ‘gn’.
In the 2nd phase there would be linear growth rate. The perpetual growth rate is known as the firms
long run normal growth rate.
The following figure illustrates the three stage growth rate.
Phase I
Phase II
Phase III
ga
gb
timeThree phase Model Of Stock Return and
Valuation
Po =aƩt=1 Do(1+ga)t
+ ^BƩt=A+1 Dt-1(1+gb) + Db(1+gn)
(1+r)t (1+r)t r-gn(1+r)B
DO= The next year dividendgn =The period ‘A’ growth rate.gb= The period ‘B’ growth rate.gn =The growth rate in the third phaseDn= The dividend at the beginning of the third
phase.
• Example: for the first 4 years ABC firm is assumed to grow at a rate of
10%.After 4 years the growth rate of dividend is assumed to decline linearly to 6%.After 7 years, the firm is assumed to grow at a rate of 6% infinitely. The next year dividend is Rs 2 and the required rate of return is 14%. Find the value of the stock.
Solution :Po =aƩt=1 Do(1+ga)t + BƩt=A+1 Dt-1(1+gb) + Db(1+gn)
(1+r)t (1+r)t r-gn(1+r)B
DO= 2r = 0.14ga = 0.1Db= declining rate of return from 10% to 6%
i.e.0.09,0.08,0.07,0.06gn= 0.06B=7 years(the beginning of the III phase)
Step 1=
AƩt=1 Do(1+ga)t
(1+r)t
= 2 + 2(1.1) + 2(1.1)2 + 2(1.1)3
(1.14) (1.14)2 (1.14)3 (1.14) 4
= 1.754 + 1.693 + 1.633 + 1.567=Rs 6.656 Step 2 = BƩt=A+1 Dt-1(1+gb) (1+r)t
=2(1.1)3 (1.09) + 2(1.1)3(1.09)(1.08) + 2(1.1)3(1.09)(1.08)(1.07) (1.14)5 (1.14)6 (1.14)7
=Rs 4.2746
Step 3 = Db(1+gn) (r-gn)(1+r)B
= 2(1.1)^3 (1.09)(1.08)(1.07)(1.06) ( 0.14-0.06) × 2.5023 = 3.554 .2001 =Rs.17.7611Step 4Add all the components of the equation Po= Rs 6.656 + 4.2746 + 17.7611Po=Rs28.69 The present value of the stock is Rs 28.69
VALUATION THROUGH P/E RATIO
• Price- earning ratios are used to estimate the value of the stock by the investors rather than adopting the discounting models.
• Advantages of P/E ratio
• P/E ratio indicates the price per rupee of share earnings. which helps to compare the prices of stocks, Which have different earnings per share.
• P/E ratio is helpful in analyzing the stock of the companies that do not pay dividend but have earnings.
• The variables used in P/E ratio model are easier to estimate than the variables in discounting model.
• The investor can also find the relative position of different stocks using P/E ratio.
• P= d/r-g•
