Ch17BondYieldsandPricesJones

Ch10BondPricesandYieldsBKM
Bondsarewhenacorporationorgovernmentborrowsmoney,payinginterestintheformofa"coupon,"
andattheendoftheprescribedlifeofthebond,theborrowermustpaybackthe"parvalue"or"face
value"ofthebond.Conveniently,"facevalue"canbeabbreviatedasFV,andthiscorrespondswith
theFVpartofourcalculationsbelow.
Muchofthiswillbebasicreview,buttermsyoushouldknow:
FACEVALUE(a.k.a."PAR")
COUPONRATE
MATURITYDATE
NOTE:Theseandotheroptionalfeaturesaredetailedinthecontractbetweenthe
issuer(company,government,etc)andtheholderofthebondwhichiscalledan
INDENTURE
YIELDS

YIELDTOMATURITY

The'i'onyourcalculator,alsothe"discountrate"

YIELDTOCALL

The'i'with'N'changedtorepresenttimeto"call"
...plusyouadda"callpremium"totheFV

CURRENTYIELD

=CouponRate/CurrentPriceoftheBond

NOTEthat NONEoftheyields arespecifiedinthe indenture.

BONDTYPES:
ZERO
STRIPS
CALLABLE
CONVERTIBLE
PUTTABLE
FLOATINGRATE
Additionaltermsandcalculations:
What'sthedifferencebetweenabondandpreferredstock?
Nominalreturnvs.Realreturn...(1+Nominalreturn)/(1+Inflation)1
FlatorCleanpriceofabondvs.theInvoiceor"Dirty"priceofabond

17Bonds

48

BONDPRICING(review)
Usingthenotationyoushouldunderstandwellbynow,asamplebondmightlooklikethis:
A5yearbond,payinga10%coupononce/yr,pricedat$1000whenissued,$1000facevalue
Theyield(i)isalso10%inthiscase(itmaydifferfromthecoupon,we'llgetintothissoon).
Remember:
Thecouponrateisnottheyield,theyieldisnotthecouponrate. Theymaybethe
same(asthisexampleshows),buttheyieldisourDISCOUNTrate.Thecouponis
whatdetermineshowmuchthebondispayingasa%offacevalue.
N
5

i
10.0%

PV
1000

PMT

FV
1000

100

=yieldor

$100.00 $100.00 $ 100.00 $100.00 $ 1,100.00

discountrate

($1,000.00)
Whatisdifferenthereisthatthefinalcashflowisnotequaltoourpreviouspaymentsbecauseitincludes
the$1000parvalueofthebondthatisduethebondholderatmaturity.Anadjustmentneedstobemade
inhowweenterandrepresentthecashflowcomponentsintheproblem.
AllweneedtodoisseparateCF5intoitstwoparts:
Thefacevalueofthebondcanbetreatedasalumpsum,
andthisisasimpleannuity.

$ 1,000.00
$100.00 $100.00 $ 100.00 $100.00 $ 100.00
1

($1,000.00)
Therefore,thePVofabondisthePVofitsannuitycashflowsPLUSthePVofitsfacevalue.

PVbond

17Bonds

PMT*[

1
(1+i)^N ]

1
i

FV
(1+i)^N

PMT*Annuityfactor(i,N)

FV*PVfactor(i,N)

PVoftheannuityportion

PVofthelumpsum

49

YourfinancialcalculatorandExcelmakethisveryeasytocalculate,butyoumustmakesureyouenterthe
componentsofthecalculationcorrectly.
Acommonmistakehereistoenter$1100fortheFV.

i
5

8.0%

PV
?

PMT

FV
RememberthattheseCFsneedseparatediscounting.
100
1000
$ 1,000.00
$100.00 $100.00 $ 100.00 $100.00 $ 100.00
0

($1,079.85)

i
5

8.0%

PV
?

PMT

FV
100

RemovetheFVandthiscalculatesthePVoftheannuity

$
$100.00 $100.00 $ 100.00 $100.00 $ 100.00
0
1
2
3
4
5
($399.27)

i
5

8.0%

100.00x(

100.00x(

100.00x(

PV
?

PMT

FV
RemovetheFVandthiscalculatesthePVoftheannuity
1000
$ 1,000.00
$
$
$
$
$
0
1
2
3
4
5
($680.58)
0

1
1.080 ^5.0
8.0%

1
1.469
8.0%

0.681

8.0%
0.319

100.00x(

8.0%
100.00x( 3.993 )

1000
1.080 ^5.0

1000
1.469

680.58

680.58

680.58

680.58

NOTE:Thisisthe"PVFactorofanAnnuity"

PVbond

17Bonds

1,079.85

399.27

50

Morecommonmistakestoavoid
First,makesureyouknowthedifferencebetweenaregularannuityandanannuitydue.
Seethelastpageofthissection.Knowhowtotogglebetween"begin"and"end"modeon
yourcalculator.
Manybondswillbedescribedashavingannualpayments(anannualcoupon),butmostwillhave
2ormorepaymentsperyear.
Youneedtoadjustthe
PMT(derivedfromtheCouponRate)
RATEor"i"
...andtheNUMBERofPERIODor"N"

Itispossiblethat"i"equalsthecouponratewhenthebondisissued,butitwillrarelybeequaltothat
valueafterthebondisissued.
Thecouponrate isthepercentageofthefacevalueofthebondthatispaidoutannually.
Therefore,thecouponrate=
e.g.

Payment/FaceValueofthebond
$100/$1000
10%coupon

Butthecouponsarefrequentlypaidsemiannuallyorpossiblyquarterly,thereforetheannualcoupon
ratecouldbe10%,butwhenpaidsemiannually,thecouponbecomes
$50perPMT,paidtwiceperyear
10
year,semiannualbond,
10.00%
Paris
$1,000.00
Howdoyousetthisupandwhat'stheprice?
N

i
20

4.50%

PV
?

coupon,

PMT
$50.00

9.00%

YTM

FV
$1,000.00

1065.04

10
Paris

year,semiannualbond,
7.00% coupon,
$1,000.00 WhatistheYTM?
N
i
PV
PMT
20
?
900.00
$35.00

$900.00

currentprice

FV
$1,000.00

4.25%
8.50% =answersemiannualPMTs
meantheyieldcalculatedisonly
semiannual,therefore,multiply*2

17Bonds

51

7.5
Paris

year,semiannualbond,
12.50% coupon,
$1,000.00 WhatistheYTM?
N
i
PV
PMT
15
?
917.25
$62.50

$917.25

currentprice

FV
$1,000.00

7.17%
14.34% =answerremember"*2"

6
Paris

year,semiannualbond,
$1,000.00
N
i
12
0.0475

9.50%
PV
1157.30

YTM

$1,157.30

PMT
?

currentprice

FV
$1,000.00

$65.00
AnnualPayment
CouponRate

$130.00
13.00%

Youholdazerocouponbondwhenthereisasuddenchangeininterestratesovernight.
5
yearstomaturity,YTMis
8.00% ,andrateschangeby
RISING
1.00%
overnight. Whathappenstothevalueofyourbond(in%and$terms)?
Note,zerocouponbondsassumesemiannualcompounding.
2
N
i
PV
PMT
FV
10
4.00% $675.56
0
1000
10

4.50% $643.93
$31.64

1000

4.68%

Youholdanannual couponbondfor1year,receivingthe
8.00%
couponjustbeforeselling.
Whenpurchasedithas
8
yearstomaturity,andtheYTMis
10.50% .Overthe
year,interestrateshave
FALLEN
by
0.50%
WhatistheHPRforthisinvestment?
N
i
PV
PMT
FV
8
10.50% $869.02
80
1000
7

10.00% $902.63

Capitalgainonthesaleofthebond

$33.61

80

1000

3.87%

(isthatit?arewedone?)

HPR

33.61 +80.00
869.02
=(Capgain+OnePMT)/PV0
13.07%

=(P1P0+Income)/P0

17Bonds

52

YIELDCURVEandtheTERMSTRUCTUREOFINTERESTRATES

ExpectationsHypothesis
Yieldstomaturityaredeterminedbyexpectationsoffutureshorttermrates
Thesealsoincludeexpectationsaboutinflation.

FORWARDRATES
Ifweknowamultiyearbondrate,wecanextracta"forward"ratethatisinferred
bythemultiyearrate.

Ifyou"know"the1yearrateof8%,youcansolveforthesecondrateifyou'regiven
onlythetwoyearrateof8.995%...
2yearret.
1yearret.

17Bonds

1.08995^2
1.0800

1.1000

the"forward"
rateforYear2

53

Usethefollowingzerocouponbondsandtheiryieldstomaturitytodetermine:
Theoneyearinterestratestartingoneyearfromnow.
Bond
a
b
c
d
e

YearstoMaturity
1
2
3
4
5

Isolatetheoneyearrateby:
1.0775 ^2
1.0725 ^1
ForwardrateONEYEARfromnow

YieldtoMaturity
7.25%
7.75%
8.25%
8.50%
8.75%

1.1610
1.0725

1.0825233 1=

1.08252331
1.09256971
1.0925347
1.09755774

8.252%
9.257%
9.253%
9.756%

1.08252331

0.08252331
8.2523%

LIQUIDITYPREFERENCELIQUIDITYPREMIUM

17Bonds

54

ARegularAnnuityvs.anAnnuityDue:
AregularannuityhasthecashflowsstructuredattheENDoftheperiods.AnAnnuityDue
hasthecashflowsattheBEGINNINGoftheperiods.Thissignificantlyaffectsthevalueof
CFs.
example:
N
PMT
i
5
$100
8%
0
RegAnn.

$ 100 $ 100 $ 100 $100 $100

$399.27 =PVoftheregularannuity

Ann.Due

$100 $ 100 $ 100 $ 100 $100

$431.21 =PVoftheannuitydue
(usetheannuitydueor"BEGIN"methodonyourcalculator)

IMPORTANT:
THISiswhyyoumustmakesureyourcalculatordoesn'tgetsetto"BEGIN"modeby
accident.Thedefaultsetting,andtheoneyou'llusealmostallthetime,istomakeyour
TimeValueofMoney(TVM)calculationsin"END"modewheretheCFsaremadeor
arriveatthe"end"oftheperiods.
TIBAII+:

TotogglebetweenENDmodeandBGNmode(andback)
2NDPMT(BGN);2NDENTER(SET);2NDCPT(QUIT)

HP12c:

ToenterBEG(Begin)mode
ToreturntoENDmode

"g"7("BEG")
"g"8("END")

Notethatcalculatorsusuallyonlydisplaywhenyou'rein"Begin"mode
(thenondefaultsetting)

17Bonds

55

PVofaGrowing(or"Graduated")Annuity
StartingwithourPVformulaforannuities,wewouldliketoaccountforannuitieswheretheCF
growsovertime.
1
1
PVA
PMT1*[
=
(1+i)^N ]
i
Doingsoissimple,andweneedonlyaddgrowth("g")tobothourdiscountfactorandthedenominator.

PVGA

PMT1*[

(1+g)
(1+i)
(i g)

1(

)^N

Thisisanannuitywevaluedearlier:a$100cashflowreceivedfor5yearswithan8%discountrate.
WecandiscounttheindividualcashflowsusingthePVFACTORS.WecanusethePVformulainExcel
ortheformulaaboveandallreturnthesamePVfortheannuity.

example:

PVFactors
PV
8%
NoGrowthCFs
ThediscountedPMTs
PVA=

N
5

Initial
CashFlow
$100

i
8%

g
3%

0
1
2
3
4
5
1.00 0.926 0.857 0.794 0.735 0.681
$
$100.00
$100.00
$100.00
$100.00
$100.00
$
$ 92.59 $ 85.73 $ 79.38 $73.50 $ 68.06
$399.27 (sumofdiscountedCFs)
$399.27 =PV(8%,5,100)
399.271 =100*(11/((1+.08)^5))/.08

TheannuitybelowisidenticaltotheaboveexceptwearegrowingtheCFby3%peryear.Thesame
valuationtechniquescanapply,butnotethatExcelandyourtypicalfinancialcalculatorsdonot
allowyoutoplugina"g"forthegrowthrate.
YouwillneedtoeitherindividuallydiscounttheCFsbythePVfactorORusethePVformulafora
growingannuity.
PVFactors
PV
8%
GrowingCFs
ThediscountedPMTs
PVGA=

17Bonds

0
1
2
3
4
5
1.00 0.926 0.857 0.794 0.735 0.681
$
$100.00
$103.00
$106.09
$109.27
$112.55
$
$ 92.59 $ 88.31 $ 84.22 $80.32 $ 76.60
$422.04 (sumofdiscountedCFs)
n/a
Exceldoesnotprovidea"growth"PVformula
422.04 =100*(1((1+.03)/(1+.08))^5)/(.08.03)

56

Important:
NOTEthatthegrowthannuityformulaisthesameastheregularannuityformulabutitaccounts
forgrowth.Ifgrowth(g)iszero,theannuityhasthesamevalueasthe"nogrowth"PVannuity.
ifg=0:

example:

PVGA

PMT1*[

100.00x(

100.00x(

399.271004 =100*(1((1+0.00)/(1+0.08))^5)/(0.080.00)
Initial
CashFlow
$100

N
5

(1+g)
(1+i)
(i g)

1(

0.080

1.030
1.080
0.030

1(

0.954

1(

i
8.0%
)^N

)^5.0

)^5.0

g
3.0%

0.050

PVGA

100.00x

0.78898

100.00x

422.04

4.2204

0.050

17Bonds

57

Ch18Bonds:AnalysisandStrategyJones
Ch11ManagingBondPortfoliosBKM
INTERESTRATERISK
InterestRateSensitivity
i.Bondpricesandyieldareinverselyrelated
ii.AnincreaseinYTMresultsinasmallerPricethananequaldecreaseinYTM
iii.PricesofLTbondstendtobemoresensitivetointerestratechangesthanSTbonds
iv.Sensitivityofbondpricestoyieldincreasesatadecliningrateasmaturityincreases
v.Interestrateriskisinverselyrelatedtothebondscouponrate.
vi.PricesensitivityisinverselyrelatedtocurrentYTM

Changeinbondpriceasafunctionofchangeinyieldtomaturity

DURATION
Whatisduration?
FrederickMacaulay:the"effectivematurityofabond"
weightedaverageofthetimesuntileachpaymentwithweightsproportional
tothePVofthepayment
weightedaverage
timesuntileachpayment
withweightsproportionalto
thePVofthepayment
Unofficialdefinition:Thetimeittakesto____________________
GETDA'MONEY

...in___________________terms.
PRESENTVALUE
Itisusedtomeasureabond's____________tochangesin_________________
SENSITIVITY
INTERESTRATES.
18ManagingBonds

58

Tocalculateduration,startwithasamplebond
N
10

i
Coupon
10%
10%

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

10

PVofCFs

First,writeoutthecashflowsforourbondanddon'tforgetthePMT+theFVinthelastperiod
$100 $100 $100 $ 100 $100 $ 100 $ 100 $ 100 $100 $1,100

$1,000

Thencreateatableofpresentvalue(discount)factors,i.e.1/(1+r)^(t)or1*(1+r)^(1)
1.00 0.909 0.826 0.751 0.683

0.621

0.564

0.513

0.467 0.424 0.386

CalculatethePVofthecashflowsfromthebond
$91 $83 $75 $ 68 $62 $ 56 $ 51 $ 47 $42 $424

$ 1,000

DeterminetheweightsoftheCFs*relativeto*thePVofthebond
9.1%

8.3%

7.5%

6.8%

6.2%

5.6%

5.1%

4.7%

4.2%

42.4%

100.0%

w(t)=(CF(t)/(1+y)^t)/Price
Multiplytheweightsandthetime(t)ittakestoreceiveeachcashflow,sumthesevaluesup,
andyouhaveduration
D=sumof("t"*w(t))
0.09 0.17 0.23 0.27

0.31

0.34

0.36

DURATION

0.37 0.38 4.24

Note,thisresultisconfirmedusingthe=Duration(...)functioninexcel

6.76

6.76

OK,thereisasimplerlookingversion,especiallyifyouhavea"shorter"bond...
N
4

i
8%

Timeto
Payment

Cash
Flow*

PVfactor
(PVof$1)

Coupon
10%

FV
$1,000

PVofCF

Weight
(PVCF/
Sumof
PVCFs)

t*W

$100 0.926

$92.59 0.087 0.087

$100 0.857

$85.73 0.080 0.161

$100 0.794

$79.38 0.074 0.223

$1,100 0.735

$808.53 0.758 3.033

SumofthePVCFs 1,066.24 1.00 3.504

18ManagingBonds

3.504

59

*NotethattheCashFlow(CF)isnotjustequaltothePMT.Whendoingthiscalculation,italso
includestheFVattheend.
N
5

i
10%

Timeto
Payment

Cash
Flow

PVfactor
(PVof
$1)**

Coupon
5%

FV
$1,000

PVofCF

Weight
(PVCF/
Sumof
PVCFs)

t*W

$50 0.909

$45.45 0.056 0.056

$50 0.826

$41.32 0.051 0.102

$50 0.751

$37.57 0.046 0.139

$50 0.683

$34.15 0.042 0.169

$1,050 0.621

$651.97 0.804 4.022

SumofthePVCFs 810.46

4.488

4.488

**NotethatyoumaynotneedtocalculatethePVfactor.JustcalculatethePVoftheCF.

N
4

i
12%

CF

PVfactor

Coupon
8%

FV
$1,000

PVofCF

Weight

t*W

$80 0.893

$71.43 0.081 0.081

$80 0.797

$63.78 0.073 0.145

$80 0.712

$56.94 0.065 0.194

$1,080 0.636

$686.36 0.781 3.125

SumofthePVCFs 878.51

3.546

3.546

***

***Youcancheckyourresult(forfun)usingtheexcelformula
=DURATION(DATE(2000,1,1),DATE(2000+N ,1,1),COUPON ,YIELD ,PMTsperyear)

Alsonote,youcancheckyourresultusingtheTIBAII+Pro,buttheduration
youwillgetis
3.1661 ,butthisistheMODIFIEDDURATION.
3.5461

18ManagingBonds

60

D of a Perpetuity = ( 1 + y ) / y
Fromthiswecanuseanalternatedurationcalculationinasingleformula
assumingthisisanannuity ,i.e.notetheprocessabovecanbeusedfor
varyingcashflows,forwhichthereareneedsanduses(asyou'llpractice).
Startwiththedurationofaperpetuityandthenadjustforcoupon
rate(c),yield(y)andtimetomaturity(N).
D=

N
4
D=

(1+y)
y

y
12.0%
1.120
0.12

[ ( 1 + y ) + N ( c - y) ]
N

c[(1+y) -1]+y
Coupon
8.0%

1.120+
0.080

9.33

1.120+
0.080

9.33

0.960
0.166
D

FV
$1,000
4
(1.120

(.080
4

1)

x0.574

0.160
+.120

9.33

3.546

.120)
+.120

5.79

SeetheDurationExercisespreadsheetunderCourseDocuments

NOWTHATYOUCANCALCULATEDURATION,HOWCANYOUUSEIT?
1)

Themainuseistocalculatethechangeinpricemovements...
P / P = -D x [ ( (1+y) / (1+y) ]
D* = D / (1+y) = "Modified" Duration
Themodificationistheadjustmentforyield,
anditallowsforaneasiertouseformulafor P
P / P = -D* x [ ( (1+y) ] = -D*y

2)

WecanalsouseittoPASSIVELYMANAGE bondportfolios

3)

ThereisanothercalculationrelatedtodurationcalledCONVEXITY.
Convexityisgenerallydesirablebecause Pishigher whenyieldsfallthanwhen
yieldsrise
P / P = -D* y + x Convexity x (y)2

18ManagingBonds

61

PASSIVEBONDMANAGEMENT
IMMUNIZATION:Astrategytoshieldassetsfrominterestratemovements
Ifwematchtheinterestrateexposureofassetsandliabilities
whetherratesriseoffall,wehavelimited/removed
____________and____________________
PRICERISK
REINVESTMENTRISK
Example:
Youareapensionfundmanagerwhohasobligationsoverthenext4yearsof
t

CF

1
2
3
4

PVofCF

5 million
2
3
4

$4.46
$1.59
$2.14
$2.54

Weight

t*W

0.416
0.149
0.199
0.237

0.416
0.297
0.597
0.947

SumPVCFs
$10.74 Million
DURATION
2.257

YouarenotabletoeasilymatchtheCFsofyour
assetstothoseofyourliabilities(theobligations).
Howwouldyouimmunizeyourportfolioifinterestratesare

12%

ACTIVEBONDMANAGEMENT
Forecast interest rate movements
If anticipate declining interest rates increase portfolio duration, and vice versa
Generate abnormal returns only if information or insight is superior to the rest of the market

CONVEXITY
DURATIONcreatesalinearestimateofthepotentialpricechanges.
Actualpricechangeiscurved.

18ManagingBonds

62

Thegraphbelow("BondValuevsYield")shows
thisacrossawiderangeofpricesandyields.In
reality,changesinyieldtendtobesmaller,and
durationisrelativelyeffectiveatestimating
pricechangesduetosmallchanges inyield.

BondValuevsYield
2,500

BondValue

2,000
1,500
1,000
500
0
0

0.05

0.1

YieldtoMaturity

0.15

Mispricingerrorduetoconvexityisless
noticeableherewhenwegraphasmaller
rangeforthechangeinyieldbasedonthe
previouslyuseddata

800
780
760
740
720
700
680
0.1025

18ManagingBonds

0.1075

0.1125

0.1175

0.1225

0.1275

63

Ch10CommonStockValuation
Ch13EquityValuation
Weusefundamentalanalysis toidentifystocksthataremispricedrelativetosome
measureoftruevalue
Bookvalue
Liquidationvalue
ReplacementcostTobinsQ(marketvaluetoreplacementcost)
Intrinsicvaluevs.marketprice
ExpectedHPRshouldequalrequiredreturn
Intrinsicvalue[E(D1)+E(P1)]/(1+k)seeking+/alpha

MEASURING/ESTIMATINGINTRINSICVALUE
Aninvestmentshouldbevaluedasthepresentvalueofitsexpectedcashflows.
Thisiseasiertodetermineforfixedorsteadycashflows,butwecanapplysimilar
techniquestovaluethecashflowsofcommonstock.
N
VCS=

CFN/(1+i)N

t=1
AboveisthesameformulaweappliedtovaluingthePVofanannuity,buttheannuity
cashflowsarefixed.Hereweassumetheycanvary,buttheconceptisthesame.
WecandiscounteachindividualcashflowtocurrentPVdollars,orwecanapplysome
oftheformulasbelowtothestockswewanttovalue.

Whatvariesfromwhatwe'veexaminedbeforeis:
Thetimingofthecashflows
Forexample,dowesellourstockinoneyearvs.tenyears?
Doesthismakeadifferenceinthepresentvalue?
Thepotentialgrowthofthecashflows

10Equities

64

First:Whatisastockworthtodaythatyouexpecttoholdforonlyayearortwo?
WestartwiththistoemphasizethetypicalCFsfromastock
1)
thedividendsastockpays
2)
thepriceforwhichweexpecttosellthestockattheendof
ourholdingperiod
i=12%
PVfactor

0
1.000

1
0.893

2
0.797

3
0.712

4
0.636

5
0.567

WewilldiscounttheCFsbelow"manually"usingthePVfactorsabove

Let'ssaywehaveastockthatweexpecttobeabletosellfor
$20.00
inthefuture.Itpays $2.40 annualdividendsattheendoftheyear.
Notethatthepriceofthestocktodayhasnothingtodowithhowlongwe
holdthestockassumingourdividendyieldisequaltoourdiscountrate.
CFs
PVofasharetodaythatweholdoneyear(receivedividend,thensellstock)
Dividends
$ 2.40
Sellingprice
$20.00
VCS=
$20.00 $20.00 $
$
$
$
CFs
Dividends
$ 2.40 $ 2.40 $ 2.40
Sellingprice
$20.00
VCS=
$20.00 $2.14 $1.91 $15.94 $

CFs
Dividends
$ 2.40 $ 2.40 $ 2.40 $ 2.40 $2.40
Sellingprice
$20.00
VCS=
$20.00 $2.14 $1.91 $1.71 $1.53 $12.71
NotethatdependingontheexpectedCFsfromastockandthediscountrate,
theholdingperiodmayhavezeroimpactonthePV

10Equities

65

TheDividendDiscountModel
The"DDM"usesthedividendsassolesourceofthecashflowsonwhichwe
willbaseourvaluationofthecompany'sstock.
Ifweassumenogrowthtothedividends,thestreamofcashflowsissimilar
toaPERPETUITY,andthemodelweusetovaluethemisthesame.
NoGrowthDDM:
CF
VCS=
r

D
i

ConstantGrowthDDM(oftencalledthe"Gordonmodel"):
D0(1+g)
D1
CF
VCS=
=
=
rg
ig
ig
Notethelackofanynotationusedforthe"Div"ordividendinthe"No
Growth"model.BecausetheDividendsinanogrowthmodel,bydefinition,
donotgrow.Theydonotchange.Div0isequaltoDiv1,andit'sequaltoDiv3
andDiv15forthatmatter.
IntheGrowthDDM,thecashflows,thedividends,areassumedtogrowat
therateequalto"g."Thereforeweuse"g"tocalculateDiv1andthisgoes
intoathecalculationofourvalueofcommonstockVCS.

FreeCashFlowModels
Larger,maturecompaniestendtopaydividends,butmanylargefirmsina
moderneconomychoosetopaylowerornodividendstofundfuturegrowth.
Therefore,modelscanbeusedtoestimatewhatafirmcouldpayout individends
V0

ExpectedFCFE
kg

FCFE1
kg

FreeCashFlowtoEquity
FCFE=
NetIncome+DepreciationDebtRepaymentsCapitalExp.
ChangeinWorkingCapital+NewDebtIssues

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66

TwoStagegrowth
Manycompanies,especiallyyounger,fastgrowingfirms,needtobeconsidered
ashavingnotonegrowthrate,buttwo(ormore).
Forthismodel,weassumeacompanyhasarapidperiodofgrowth,anditthen
levelsoffafterthecompanymaturesandbecomeslarger.
Werefertothesetwogrowthratesmerelyas:
g 1 : Theinitial,fasterperiodofgrowth,e.g.fromnowto3
ormaybeeven10yearsout
g 2 : Thesecondstageoflower,constantgrowth
Theformulafordoingthiswilllookcomplex,butbybreakingthestreamof
cashflowsintotwoparts,ittakestheshapeof
1)
AnannuityofCFsofthegrowthperiod"N"
ThePVofthestreamofdividendsafterthegrowth
2)
period "N"

Thereforethevalueofourcommonstocklookslikethis:
VCS=

D0(1+g1)*[

PVGA

(1+g1)
(1+i)

^N

PV0(PVGrowthPerp@N)

DN+1
]+

(1+i)N

(i g1)

D0(1+g1)*[

(1+g1)
(1+i)

(i g1)

(ig2)

^N

D0(1+g1)N(1+g2)
]+

(ig2)
(1+i)N

ThreeStageGrowthModel
Thetwostagegrowthmodelassumesaninstantaneousswitchfromthehigh
growthratetothelowerrate,e.g.growingat20%for5yearsandthen
suddenlydroppingto5%thereafter.
Athreestagemodelassumesaperiodinthemiddlewherethegrowthdeclines
linearlyfromthehighgrowthperiodtothelowgrowthperiod.

10Equities

67

Thisismorerealisticandisrepresentedbytheequationbelow:

VCS=

D0
ig2

* (1+g2)+

(N1+N2)
2

*(g1g2)

Youmayskipthis,butnotetherearemanyversionsofthismodel.Itisprimarilyused
tocaptureamorerealisticdeclineingrowth,butsomemodelsalsocapturechanging
dividendpayoutrates.

TheEarningsand/orPVGOModel
Thusfar,weassumeagivengrowthrate(orrates)asgiven,butweknowfrom
theDuPontdeconstructionofROEthatmanagementhassignificantcontrol
overthefirmandhowthatrelatestoreturns.
First,afirmmustinvestinfuturegrowth.Itdoesnotmagicallyappear,and
thisgrowthisafunctionoftwofactors:theamountofinvestmentinfuture
growth,andtheabilityofmanagementtocapitalizeonthatinvestment
effectively.
Wethereforegetour"g"fromtheretainedearningsandourROE,specifically
itis
g= b*ROE
growthrate= Retentionratio *ReturnonEquity
Forexample:IfafirmhasanROEof15%,wewouldexpectittobeableto
growatarateofg asfollows:
g= b*ROE
Growth
rate

0.0%
3.8%
7.5%
11.3%
15.0%

10Equities

Retention
%

0.0%
25.0%
50.0%
75.0%
100.0%

ROE%

15.0%
15.0%
15.0%
15.0%
15.0%

68

Thisshouldmakeitclearthatifafirmpaysoutallit'searnings(e.g.EPS)as
dividends(D),thentherearenofundtoinvestingrowth,therefore"g"is
zero,andwecanvaluethefirmwiththesameformulaweusefora
perpetuity(above)andourNoGrowthDividendDiscountModel(DDM).
NoGrowthDDM:
CF
VCS=
r

D
i

EPS1
k

Seethatwecanuse"r","i",and"k"asnotationforthesamething
therequiredrateofreturn,thediscountrate,theinterestrate,
theWACC,etc.

However,ifwe'regoingtoinvestingrowth,wewon'tbepaying100%ofour
earningsasdividends,thereforeweseparatethevalueofthefirmintotwo
pieces,thevaluefromtheexpectedcashflows,andthevalueofthegrowth
opportunities(thePVGO)wecreatewithournewinvestmentusingthe
retainedearnings.
VCS=

EPS1
k

PVGO

RE1*(ROE/k1)
kg

WesolveforthePVGOas
PVGO=

NPV1
kg

Notethatbecausethevaluationmodelscontainvariousassumptionsorrelytovaryingdegrees
onhistoricaldataorratios,theINTRINSICVALUEStheyproducecanvarysignificantly.
Example:HondaMotorCo.2008

10Equities

69

PRICETOEARNINGSRATIOS
ThiswillbecoveredduringourdiscussionofRATIOSin"CompanyAnalysis"(Ch15Jones)
P/Eratioscancontainagreatdealofinformationaboutacompany,butwe
shouldn'tdrawconclusionsthataretoobroadfromthisdatapointalone.
HighP/Ecompaniesareusuallyassociatedwithhighergrowth
Understandthedifferencebetween
P/E TTM andP/E Forward
LowP/Efirms,thereforeareoftenlowergrowth,BUTthisdoesnotmean
theyarelowrisk.
ALOWP/Ecouldbetheresultofahigh"k"...
P0
E1

(1b )

k g

1 40%

12% 6%
10.0

Higherriskstocksshouldhaveahigherreturn,thereforethe"k"ishigher.

PEGRatio

P/E
g

AcommonruleofthumbisthatafairlypricedstockwillhaveaP/Eratiocloseto
itsgrowthrate.ThiswouldmeanthePEGratioshouldbeabout1.0forafairly
pricedstock.
WheretheP/EratioislessthanthegrowthrateORthePEG<1.0,thefirmmay
beabargain.
(Source:PeterLynch,OneUponWallStreet)
Inreality,PEGratiostypicallyfluctuatebetween1.0and1.5.

10Equities

70

WecanseewhyhigherP/Eratiosindicateamplegrowthopportunitiesbecause...
...wecanexpresstheforwardP/Eratioas
P0
E1

1
k

+[

PVGO
E1/k

Andweknowthatthepriceofastockcanbeexpressedas
P0

D1
kg

D1equalstheamountofearningswearenotretaining,or
=E1(1b)

D1

andsincegrowthisafunctionofROEandtheretainedearnings
asg=ROE*b,thelatterbeingtheplowbackorretentionratio
P0

therefore

P0
E1

D1
kg

E1(1b )
k (ROExb )

(1b )

(1b )

k g

k (ROExb )

THISistheP/Eratioforafirmgrowingalongrunsustainablepace.

Ex: Price/Share
EPS

$12
$1

HasaforwardP/Eof

Thefirm'srequiredrateofreturn
ReturnonEquityis
Thefirmpaysoutearningsata

12%
15%
40%

Thereforethefirm'ssustainableP/Eratiowouldbe
P0
E1

(1b )
k (ROE*b )

13.3
=

10Equities

12.0

160%
(12%

15%x 60%)
40%
3%

71

WhataretheimplicationsofafirmhavingasustainableP/Eratio lessthan
itscurrentP/Eratio?
WhataboutanegativevalueforasustainableP/Eratio?Whatdoesthis
indicate?

PitfallsofP/Eratios
Earningsare"accountingearnings."
Analystsfocuson"earningsquality"attimestoaccountforinflation,
onetimecharges,etc.
Earningscanbe"managed"

OtherratiosComparativeValuation
PricetoBook
PricetoCashFlow
PricetoSales

10Equities

72

Ch15CompanyAnalysisJones
Ch14FinancialStatementAnalysis&RatiosBKM
Thischapterreviewsanumberofaccountingmeasuresandratiosweuseinfundamental
analysis.Iwon'tbespendingmuchtimereviewingthebasics.

Itwouldbeworthwhiletoreviewalltheratioscoveredinthischapterifyouarenot
veryfamiliarwiththem.Havingtheformulasinyournotesfortheexamwouldalsobe
wise.

FromthesectiononCompanyStockValuation,notethediscussionRE:P/Eratiosand
thePEGratio.Thistopictendstocrossintoboth"chapters"ofeachtext.

InadditiontotheusualratiosandP/E,wewillfocusonReturnonEquity(ROE),how
managerialdecisionscandirectlyaffectit,andhowtheresultingROEdirectlyaffectsfirmvalue.

15CompanyAnalysisRatios

73

TheDuPontSystemDeconstructingReturnonEquity
ROE

NetIncome
Equity

MeasureofManagementEffectiveness
Also:ReturnonBookEquity,ReturnonNetWorth

IsROEthesameasROA?Howdoesitdiffer?
ROE

NetIncome
Equity

NetIncome
Equity

Assets
Assets

NetIncome
Assets

Assets
Equity

ROA

EquityMultiplier

ROE

NetIncome
Equity

Sales
Sales

Assets
Assets

ROE

NetIncome
Sales

Sales
Assets

Assets
Equity

Profit Margin

Total Asset Turnover

Equity Multiplier

(SalesMultiple)

$1.60
$32.00

ROE

=NI/Equity
=ROA*Eq.Multiplier

ROA
ROA*=NI/Assets

$32.00
$16.00

(LeverageRatio)

$16.00
$10.00

5.0%

200%

1.60

$1.60
$10.00

16.0%

DebttoEquity
60%

$1.60
$16.00

10.0%

*Notethatsomeauthors/analystssuggestusingOperatingIncomeinsteadofNetIncomeinthiscalculation

15CompanyAnalysisRatios

74

Notehowthevariousdecisionsavailabletomanagementinrunningthefirmleadto
changesinROE,andthisleadsdirectlytochangesinfirmvalue.
EPS1
PayoutRatio
ROE
RequiredReturn

2.15
45.0%
17.0%
13.0%

GrowthRate(g)

9.35%

ValuewithoutGrowth
ValueofGrowthOppt's
ValueofStock

ROE
10%
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%

Value
12.90
13.92
15.12
16.54
18.25
20.37
23.04
26.51
31.21
37.94
48.38

15CompanyAnalysisRatios

Notethatifweusethe
ConstantGrowthDDM
thevalueis...
26.51

RE1*(

EPS1

RE1

$0.97 $1.18

16.54
9.97
26.51

ROE
k
kg

1)

StockValueasROERises

StockValue

VCS=

Div1

60.00
50.00
40.00
30.00
20.00
10.00

10%

12%

14%

16%

18%

20%

ReturnonEquity

75

TheDuPontSystemDeconstructingReturnonEquity
ROE
NetIncome
MeasureofManagementEffectiveness
Equity
Also:ReturnonBookEquity,ReturnonNetWorth
IsROEthesameasROA?Howdoesitdiffer?
ROE

NetIncome
Equity

NetIncome
Equity

Assets
Assets

NetIncome
Assets

Assets
Equity

ROA

EquityMultiplier

ROE

NetIncome
Equity

Sales
Sales

Assets
Assets

ROE

NetIncome
Sales

Sales
Assets

Assets
Equity

Profit Margin

Total Asset Turnover

Equity Multiplier

(net)

(SalesMultiple)

(LeverageRatio)

$1.60
$32.00

ROE

=NI/Equity
=ROA*Eq.Multiplier

ROA
ROA*=NI/Assets

$32.00
$16.00

$16.00
$10.00

5.0%

200%

1.60

$1.60
$10.00

16.0%

DebttoEquity
60%

$1.60
$16.00

10.0%

*Notethatsomeauthors/analystssuggestusingOperatingIncomeinsteadofNetIncomeinthiscalculation

76

TheDuPontSystemDeconstructingReturnonEquity
ROE
NetIncome
MeasureofManagementEffectiveness
Equity
Also:ReturnonBookEquity,ReturnonNetWorth
IsROEthesameasROA?Howdoesitdiffer?
ROE

NetIncome
Equity

NetIncome
Equity

Assets
Assets

NetIncome
Assets

ROA

Assets
Equity
EquityMultiplier

ROE

NetIncome
Equity

PretaxProfit
PretaxProfit

EBIT
EBIT

Sales
Sales

Assets
Assets

ROE

NetIncome
PretaxProfit

PretaxProfit
EBIT

EBIT
Sales

Sales
Assets

Assets
Equity

NI
(EBITInt.Exp.)

(EBITInt.Exp.)
EBIT

EBIT
Sales

Sales
Assets

Assets
Equity

formulas

TaxBurden

InterestBurden

Margin

AssetTurnover

Leverage

(shareaftertaxes)

(shareafterinterestpmts)

(gross,notnet)

(SalesMultiple)

(EquityMultiplier)

$1.33
$2.30

$2.30
$3.84

$3.84
$32.00

$32.00
$16.00

$16.00
$10.00

valueusedforROE 0.58

0.60

0.12

2.00

1.60

isactuallytheamount"kept"forbothvalues,notreallythe"burden"

ROE

ROA

DuPont5way

42.2%

40%

NetTax%

NetInt.%ofEBIT

12%

$1.33
$10.00

13.3%

ROE=NI/Equity=ROA*Eq.Multiplier

$1.33
$16.00

ROA=NI/Assets

0.133

2.0x
or200%

1.6x
or160%
DebttoEquity
60%

8.3%

77