C
PV
r g
ZeroCoupon Bonds
ZeroCoupon Bond
Does not make coupon payments
Always sells at a discount (a price lower than face
value), so they are also called pure discount
bonds
Treasury Bills are U.S. government zerocoupon
bonds with a maturity of up to one year.
25
ZeroCoupon Bonds (cont'd)
Suppose that a oneyear, riskfree, zerocoupon
bond with a $100,000 face value has an initial
price of $96,618.36. The cash flows would be:
Although the bond pays no interest, your
compensation is the difference between the initial
price and the face value.
26
ZeroCoupon Bonds (cont'd)
Yield to Maturity
The discount rate that sets the present value of
the promised bond payments equal to the current
market price of the bond.
Price of a ZeroCoupon bond
27
(1 )
=
+
n
n
FV
P
YTM
ZeroCoupon Bonds (cont'd)
Yield to Maturity
For the oneyear zero coupon bond:
Thus, the YTM is 3.5%.
28
1
100,000
96,618.36
(1 )
=
+ YTM
1
100,000
1 1.035
96,618.36
+ = = YTM
ZeroCoupon Bonds (cont'd)
Yield to Maturity
Yield to Maturity of an nYear ZeroCoupon Bond
29
1
1
 
=

\ .
n
n
FV
YTM
P
Example
30
Example (cont'd)
31
ZeroCoupon Bonds (cont'd)
RiskFree Interest Rates
A defaultfree zerocoupon bond that matures on
date n provides a riskfree return over the same
period. Thus, the Law of One Price guarantees
that the
riskfree interest rate equals the yield to maturity
on such a bond.
RiskFree Interest Rate with Maturity n
32
=
n n
r YTM
Coupon Bonds
Coupon Bonds
Pay face value at maturity
Pay regular coupon interest payments
Treasury Notes
U.S. Treasury coupon security with original
maturities of 110 years
Treasury Bonds
U.S. Treasury coupon security with original
maturities over 10 years
33
Example
34
Example (cont'd)
35
Coupon Bonds (cont'd)
Yield to Maturity
The YTM is the single discount rate that equates
the present value of the bonds remaining cash
flows to its current price.
Yield to Maturity of a Coupon Bond
36
1 1
1
(1 ) (1 )
 
= +

+ +
\ .
N N
FV
P CPN
y y y
Interest Rate Changes and Bond Prices
There is an inverse relationship between
interest rates and bond prices.
As interest rates and bond yields rise, bond prices
fall.
As interest rates and bond yields fall, bond prices
rise.
37
The Yield Curve and Bond Arbitrage
Using the Law of One Price and the yields of
defaultfree zerocoupon bonds, one can
determine the price and yield of any other
defaultfree bond.
The yield curve provides sufficient information
to evaluate all such bonds.
38
Valuing a Coupon Bond
Using ZeroCoupon Yields
The price of a coupon bond must equal the
present value of its coupon payments and
face value.
Price of a Coupon Bond
39
2
1 2
(Bond Cash Flows)
V
1 (1 ) (1 )
=
+
= + + +
+ + +
n
n
PV PV
CPN CPN CPN F
YTM YTM YTM
2 3
100 100 100 1000
$1153
1.035 1.04 1.045
+
= + + = P
Coupon Bond Yields
Given the yields for zerocoupon bonds, we
can price a coupon bond.
40
2 3
100 100 100 1000
1153
(1 ) (1 ) (1 )
+
= = + +
+ + +
P
y y y
2 3
100 100 100 1000
$1153
1.0444 1.0444 1.0444
+
= + + = P
Treasury Yield Curves
Treasury CouponPaying Yield Curve
Often referred to as the yield curve
OntheRun Bonds
Most recently issued bonds
The yield curve is often a plot of the yields on
these bonds.
41
Corporate Bonds
Corporate Bonds
Issued by corporations
Credit Risk
Risk of default
42
Corporate Bond Yields
Investors pay less for bonds with credit risk
than they would for an otherwise identical
defaultfree bond.
The yield of bonds with credit risk will be
higher than that of otherwise identical
defaultfree bonds.
43
Corporate Yield Curves for Various
Ratings, September 2005
44
Valuation of Shares
45
Stock Prices, Returns,
and the Investment Horizon
A OneYear Investor
Potential Cash Flows
Dividend
Sale of Stock
Timeline for OneYear Investor
Since the cash flows are risky, we must discount them at the
equity cost of capital.
46
Stock Prices, Returns,
and the Investment Horizon (cont'd)
A OneYear Investor
If the current stock price were less than this
amount, expect investors to rush in and buy it,
driving up the stocks price.
If the stock price exceeded this amount, selling it
would cause the stock price to quickly fall.
47
1 1
0
1
 
+
=

+
\ . E
Div P
P
r
Dividend Yields, Capital Gains,
and Total Returns
Dividend Yield
Capital Gain
Capital Gain Rate
Total Return
Dividend Yield + Capital Gain Rate
The expected total return of the stock should equal the
expected return of other investments available in the market
with equivalent risk.
48
1 0 1 1 1
0 0 0
Dividend Yield Capital Gain Rate
1
+
= = +
E
P P Div P Div
r
P P P
A MultiYear Investor (cont'd)
What is the price if we plan on holding the
stock for N years?
This is known as the Dividend Discount Model.
49
1 2
0
2
E E E E
1 (1 ) (1 ) (1 )
= + + + +
+ + + +
N N
N N
Div P Div Div
P
r r r r
A MultiYear Investor (cont'd)
The price of any stock is equal to the present
value of the expected future dividends it will
pay.
50
3 1 2
0
2 3
1
E E E E
1 (1 ) (1 ) (1 )
=
= + + + =
+ + + +
n
n
n
Div Div Div Div
P
r r r r
The DiscountDividend Model
Constant Dividend Growth
The simplest forecast for the firms future
dividends states that they will grow at a constant
rate, g, forever.
51
The DiscountDividend Model (cont'd)
Constant Dividend Growth Model
The value of the firm depends on the current dividend
level, the cost of equity, and the growth rate.
52
1
0
E
=
Div
P
r g
1
E
0
= +
Div
r g
P
Dividends Versus Investment and
Growth
A Simple Model of Growth
Dividend Payout Ratio
The fraction of earnings paid as dividends each year
53
E
Earnings
Dividend Payout Rate
Shares Outstanding
=
t
t
t t
t
PS
Div
Dividends Versus Investment
and Growth (cont'd)
A Simple Model of Growth
Assuming the number of shares outstanding is
constant, the firm can do two things to increase
its dividend:
Increase its earnings (net income)
Increase its dividend payout rate
54
Dividends Versus Investment
and Growth (cont'd)
A Simple Model of Growth
A firm can do one of two things with its earnings:
It can pay them out to investors.
It can retain and reinvest them.
55
Dividends Versus Investment
and Growth (cont'd)
A Simple Model of Growth
Retention Rate
Fraction of current earnings that the firm retains
56
Change in Earnings New Investment Return on New Investment =
New Investment Earnings Retention Rate =
Dividends Versus Investment
and Growth (cont'd)
A Simple Model of Growth
If the firm keeps its retention rate constant, then
the growth rate in dividends will equal the growth
rate of earnings.
57
Change in Earnings
Earnings Growth Rate
Earnings
Retention Rate Return on New Investment
=
=
Retention Rate Return on New Investment = g
Dividends Versus Investment
and Growth (cont'd)
Profitable Growth
If a firm wants to increase its share price, should it
cut its dividend and invest more, or should it cut
investment and increase its dividend?
The answer will depend on the profitability of the
firms investments.
Cutting the firms dividend to increase investment will raise
the stock price if, and only if, the new investments have a
positive NPV.
58
Example
59
Example (cont'd)
60
Changing Growth Rates
We cannot use the constant dividend growth
model to value a stock if the growth rate is
not constant.
For example, young firms often have very high
initial earnings growth rates. During this period of
high growth, these firms often retain 100% of
their earnings to exploit profitable investment
opportunities. As they mature, their growth slows.
At some point, their earnings exceed their
investment needs and they begin to pay
dividends.
61
Changing Growth Rates (cont'd)
Although we cannot use the constant dividend
growth model directly when growth is not
constant, we can use the general form of the
model to value a firm by applying the constant
growth model to calculate the future share
price of the stock once the expected growth
rate stabilizes.
62
Changing Growth Rates (cont'd)
DividendDiscount Model with Constant Long
Term Growth
63
1
E
+
=
N
N
Div
P
r g
1 1 2
0
2
E E E E E
1
1 (1 ) (1 ) (1 )
+
 
= + + + +

+ + + +
\ .
N N
N N
Div Div Div Div
P
r r r r r g
Example
64
Example (cont'd)
65
66
The Discounted Free Cash Flow Model
Discounted Free Cash Flow Model
Determines the value of the firm to all investors,
including both equity and debt holders
The enterprise value can be interpreted as the net
cost of acquiring the firms equity, taking its cash,
paying off all debt, and owning the unlevered
business.
Enterprise Value Market Value of Equity Debt Cash = +
67
The Discounted Free Cash
Flow Model (cont'd)
Valuing the Enterprise
Discounted Free Cash Flow Model
Unlevered Net Income
Free Cash Flow (1 ) Depreciation
Capital Expenditures Increases in Net Working Capital
= t +
c
EBIT
0
(Future Free Cash Flow of Firm) = V PV
0 0 0
0
0
Cash Debt
Shares Outstanding
+
=
V
P
68
The Discounted Free Cash
Flow Model (cont'd)
Implementing the Model
Since we are discounting cash flows to both equity
holders and debt holders, the free cash flows
should be discounted at the firms weighted
average cost of capital, r
wacc
. If the firm has no
debt, r
wacc
= r
E
.
69
The Discounted Free Cash
Flow Model (cont'd)
Implementing the Model
Often, the terminal value is estimated by
assuming a constant longrun growth rate g
FCF
for
free cash flows beyond year N, so that:
1 2
0
2
wacc wacc wacc wacc
1 (1 ) (1 ) (1 )
= + + + +
+ + + +
N N
N N
FCF V FCF FCF
V
r r r r
1
wacc wacc
1
( )
+
 
+
= =

\ .
N FCF
N N
FCF FCF
FCF g
V FCF
r g r g
70
Example
71
Example (cont'd)
72
The Discounted Free Cash
Flow Model (cont'd)
Connection to Capital Budgeting
The firms free cash flow is equal to the sum of the
free cash flows from the firms current and future
investments, so we can interpret the firms
enterprise value as the total NPV that the firm will
earn from continuing its existing projects and
initiating new ones.
The NPV of any individual project represents its
contribution to the firms enterprise value. To maximize
the firms share price, we should accept projects that
have a positive NPV.
73
Valuation Based on Comparable Firms
Method of Comparables (Comps)
Estimate the value of the firm based on the value
of other, comparable firms or investments that we
expect will generate very similar cash flows in the
future.
74
Valuation Multiples
Valuation Multiple
A ratio of firms value to some measure of the
firms scale or cash flow
The PriceEarnings Ratio
P/E Ratio
Share price divided by earnings per share
75
Valuation Multiples (cont'd)
Trailing Earnings
Earnings over the last 12 months
Trailing P/E
Forward Earnings
Expected earnings over the next 12 months
Forward P/E
76
Valuation Multiples (cont'd)
Firms with high growth rates, and which
generate cash well in excess of their
investment needs so that they can maintain
high payout rates, should have high P/E
multiples.
0 1 1
1 E E
/ Dividend Payout Rate
Forward P/E
= = =
P Div EPS
EPS r g r g
77
Example
Problem
Best Buy Co. Inc. (BBY) has earnings per share
of $2.22.
The average P/E of comparable companies stocks
is 19.7.
Estimate a value for Best Buy using the P/E as a
valuation multiple.
78
Solution
The share price for Best Buy is estimated by
multiplying its earnings per share by the P/E of
comparable firms.
P
0
= $2.22 19.7 = $43.73
79
Stock Valuation Techniques:
The Final Word
No single technique provides a final answer
regarding a stocks true value. All approaches
require assumptions or forecasts that are too
uncertain to provide a definitive assessment
of the firms value.
Most realworld practitioners use a combination
of these approaches and gain confidence if the
results are consistent across a variety of methods.