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Chapter

Valuation and Rates of Return

PPT 10-2

Chapter 10 - Outline
Valuation Concepts Valuation of Bonds 3 Factors that Influence the Required Rate of Return Relationship Between Bond Prices and Yields Preferred Stock Valuation of Common Stock Valuation Using the Price-Earnings Ratio Summary and Conclusions

PPT 10-3 / The relationship between time value of money, required return, cost of financing, and investment decisions

Figure 10-1

Chapter 10
Required rates of return by investors

Chapter 9
Present value concepts

Chapter 11
Cost of financing to the firm

Chapters 12 and 13
Analysis of projects based on cost of financing to the firm

Valuation

PPT 10-4

Valuation Concepts
The value or price of a stock or bond is based upon the present value of future expected cash flows to the investor

The discount rate used is investors required rate of return, based on the markets estimates of risk, efficiency, and expected future returns

PPT 10-5

Valuation of Bonds
The value of a bond is made up of 2 parts:
PV of the interest payments (an annuity) PV of the principal payment (a lump sum)

The principal payment at maturity:


can also be called the par value or face value is usually $1,000

The interest rate used:


is the yield to maturity or discount rate is also the required rate of return

The present value (price) of a bond


Pb =

t =1

It Pn + (1 + Y ) t (1 + Y ) n

where : Pb = the market price of the bond It = the periodic interest payments Pn = the principal payment at maturity t = the period from 1 to n n = the total number of periods Y = the yield to maturity (required rate of return)

Relationship Between Bond Prices and Yields

PPT 10-8

Bond prices are inversely related to bond yields (move in opposite directions) As interest rates in the economy change, the price or value of a bond changes:
if the required rate of return increases, the price of the bond will decrease if the required rate of return decreases, the price of the bond will increase

Bond price and required rate of return(yield to maturity)


If the market rate is higher than the coupon rate (the annual interest payment divided by the par value), the bond will sell at discount (below par value) If the market rate is equal to the coupon rate, the bond will sell at par value If the market rate is lower than the coupon rate, the bond will sell at premium ( above par value)

Table 10-1

PPT 10-7

Bond price table


(10 Percent Interest Payment, 20 Years to Maturity) Yield to Maturity Bond Price 2 4 6 7 8 9 10 11 12 13 14 16 20 25 % . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,308.11 1,815.42 1,458.80 1,317.82 1,196.36 1,091.29 1,000.00 920.37 850.61 789.26 735.07 644.27 513.04 406.92

3 Factors that Influence the Required Rate of Return


Real Rate of Return:

PPT 10-6

represents the opportunity cost of the investment in the early 1990s, 5-7%, but now about 3-4%
Inflation Premium:

a premium to compensate for the effects of inflation lately, 2%


Risk Premium:

a premium associated with business and financial risk typically, 2-6%


So, the Required Rate of Return equals:

Real Rate of Return + Inflation Premium + Risk Premium

Bond price, required rate of return, time to maturity


Bond prices are inversely related to required rate of return. A change in the required rate of return will cause a change in the bond price in the opposite direction The impact of the change in required rate of return on the bond price is depend upon the remaining time to maturity. The impact will be greater the longer the time to maturity.

PPT 10-9

Table 10-2

Impact of time to maturity on bond prices


Time Period in Years (of 10 percent bond) Bond Price with 8 Percent Yield to Maturity Bond Price with 12 Percent Yield to Maturity

0 . . . . . . . . 1 . . . . . . . . 5 . . . . . . . . 10 . . . . . . . . 15 . . . . . . . . 20 . . . . . . . . 25 . . . . . . . . 30 . . . . . . . .

$1,000.00 1,018.52 1,079.85 1,134.20 1,171.19 1,196.36 1,213.50 1,225.16

$1,000.00 982.14 927.90 887.00 863.78 850.61 843.14 838.90

Figure 10-2

PPT 10-10

Relationship between time to maturity and bond price*


Bond Price ($) 1,300 1,200 1,100 1,000 900 800 700 Assumes 12% yield to maturity 10% bond, $1,000 par value Assumes 8% yield to maturity

30

25

15 5 Number of years to maturity

* The relationship in the graph is not symmetrical in nature.

PPT 10-11

Reading Bond Quotations


Company Name (interest rate %)
Your Daily Paper
Issuer Coupon Maturity Price Yield Change

Coupon

(April 8, 2022)

Maturity Date

BC Tel

9.65

Apr 8-22 138.5

6.488

+1.118

(Last transaction price = $138.50/ $100 of face value)

Price

(Closing Yield price up $1.12/ (Annual interest $100 from Market price) previous day)

Change

Compute the yield to maturity


Trial and error process Interpolation method A less exact calculation of the yield to maturity

Approximate Yield
to Maturity

Principal -Price of the bond Annual interest payment + Number of years to maturity . 6 (Price of the bond) +.4( Principal payment)

Valuation of Preferred Stock


Preferred stock:

PPT 10-12

usually represents a perpetuity (something with no maturity date) has a fixed dividend payment is valued without any principal payment since it has no ending life is considered a hybrid security owners have a higher priority of claim than common shareholders price is based upon PV of future dividends

Valuation of Preferred Stock

D Pp = + + + + 1 2 3 (1+ K p ) (1+ K p ) (1+ K p ) (1+ K p ) = Dp Kp

Dp

Dp

Dp

Valuation of Common Stock

PPT 10-13

The value of common stock is the present value of a stream of future dividends Common stock dividends can vary, unlike preferred stock dividends There are 3 possible cases:
No growth in dividends (valued like preferred stock) Constant growth in dividends Variable growth in dividends

Required rate of return reflects the dividend yield on the stock and the expected growth rate in the dividend

Valuation of Common Stock


General formula
P0 =
n

D3 D1 D2 D + + + + (1 + K e )1 (1 + K e ) 2 (1 + K e ) 3 (1 + K e )

Dt Pn Dt = + = t (1 + K e ) n t =1 (1 + K e ) t t =1 (1 + K e )

No growth in dividends
P0 = D0 Ke D1 Ke g

Constant growth in dividends


P0 =

PPT 10-14

Valuation Using the Price-Earnings Ratio


The Price-Earnings (P/E) ratio can also be used to value common stocks The P/E ratio is influenced by many factors:

the earnings and sales growth of the firm the risk (or volatility in performance) the debt-equity structure the dividend policy the quality of management a number of other factors
The average P/E ratio for TSX Composite, excluding Nortel and JDS Uniphase, in early 2002 was 33 to 1

PPT 10-15

High vs. Low P/Es


A stock with a high P/E ratio:
indicates positive expectations for the future of the company means the stock is more expensive relative to earnings typically represents a successful and fast-growing company is called a growth stock

A stock with a low P/E ratio:


indicates negative expectations for the future of the company may suggest that the stock is a better value or buy is called a value stock

Table 10-4

An example of stock quotations from the Globe and Mail

PPT 10-16

Source: ILX Systems, a division of Thomson Information Services Inc.

PPT 10-17

Reading Stock Quotations


Stock
(Total number of (Last price paid shares traded (100s) at close of trading)
Your Daily Paper
Company Volume High Low Close Change

Volume

Close

(Highest price paid per share for the day was $29.15)

High

Inco

3760

29.150

28.500

28.600

-.400

(Lowest price paid per share for the day was $28.50)

Low

(Difference between todays price and previous days. A .40 decrease)

Change

PPT 10-18

Valuation of a Supernormal Growth Firm

Stock valuation under supernormal growth

D0 (1 + g s ) t D0 (1 + g s ) n P0 = + t (1 + K e ) ( K e g c )(1 + K e ) n t =1
n

Figure 10B-1

PPT 10-19

Stock valuation under supernormal growth analysis

PPT 10-20

Summary and Conclusions

The value of securities is based upon the present value of expected future cash flows from the investment, discounted at the rate of return required by investors The required rate of return includes premiums for expected inflation and the perceived risk of the investment

The price of a bond reflects the present value of future payments of interest and principal, discounted at current market bond yields The price of a preferred or common stock reflects the present value of future dividends, discounted at current market dividend yields An alternative for valuing common stock is the price-earnings ratio